What is the Times-Revenue Method?
The times-revenue method determines the maximum value of a company as a multiple of its revenue over a set period of time. The multiple can vary by industry and other factors, typically ranging between one or two, but in some industries, it might be less.
Key Takeaways
- The times-revenue method is used to gauge the maximum value of a company based on its revenue.
- This method generates a range of values based on the company’s revenue over a previous period.
- Valuation using this method will vary from one industry to another due to differing growth potentials.
- Revenue does not equate to profit, making this method sometimes less reliable as a valuation tool.
- Its simplicity makes it easy to calculate, especially if reliable revenue totals are already available.
Understanding the Times-Revenue Method
The value of a business might need to be determined for various reasons, such as financial planning or a potential sale. Calculating this value, especially if dependent on future revenues, can be complex. Several models exist to derive this value, aiding in business decision-making. The times-revenue method values a business based on its cash flow by multiplying its actual revenues over a specified period by a certain multiple.
This multiple depends on industry-specific factors. In small business valuation, a ‘floor’ (the lowest price someone would pay, often the liquidation value) and a ‘ceiling’ (the maximum price a buyer might pay, often a multiple of current revenues) are set. This valuation range helps owners determine what someone might be willing to pay for the business. Factors like the macroeconomic environment and industry conditions also influence the choice of multiple. This method is also known as the multiples of revenue method.
Who Can Benefit from the Times-Revenue Method?
Young companies with volatile or non-existent earnings, like software-as-a-service firms poised for rapid growth, can benefit from using the times-revenue method. If the company or industry is on the brink of significant expansion, the multiple used might be higher. They may value these growth-phase businesses at three to four-times their revenue due to their high recurring revenue and good margins. Conversely, firms with low growth potential or recurring revenue might be valued at around 0.5 times their revenue.
Criticism of the Times-Revenue Method
The major limitation of the times-revenue method is that it doesn’t always align with a firm’s actual value because revenue doesn’t necessarily mean profit. For instance, a business may see a 10% increase in revenue but face a 25% hike in expenses. Revenue-only valuations ignore the cost of generating that revenue, suggesting that earnings should also be factored in, as captured better by the multiples of earnings method.
The times-revenue calculation can be twofold:
- Dividing the purchase price by annual revenue to get the multiple.
- Multiplying annual revenues by the desired revenue multiple to determine a target price.
Example of the Times-Revenue Method
Consider X (formerly Twitter), which reported annual revenue of $5.077 billion in 2021. Elon Musk’s $44 billion acquisition of the company equates to approximately 8.7 times its revenue. Despite this valuation, X faced a net annual loss of $221 million the same year, highlighting the model’s limitation since the method didn’t factor in profitability.
How Do You Calculate Times-Revenue?
Times-revenue is calculated by dividing the selling price of a company by its revenue over the past 12 months, indicating how many times annual income a buyer was willing to pay.
What is a Good Times-Revenue Multiple?
The ideal times-revenue multiple varies across companies and industries, largely based on growth potential. Companies in higher-growth sectors often have higher multiples due to their revenue-generating potential, while smaller, riskier businesses may bear lower multiples.
How is the Times-Revenue Method Used?
This method sets a benchmark purchase price for businesses. Using only the company’s revenue, buyers and sellers can estimate a reasonable selling price by adjusting the times-revenue multiple.
Is a Low Times Multiple Bad?
Not necessarily. A low times multiple indicates a lower company value compared to its peers. For motivated sellers, it might attract buyers seeking a bargain.
The Bottom Line
The times-revenue method is straightforward, given its formula: revenue multiplied by a chosen factor yields the company’s value. However, its major flaw is that it doesn’t consider costs, thereby potentially misrepresenting a firm’s true value. All valuation methods do share a common limitation: they are based on historical performance and can’t precisely predict future sales.
Related Terms: Earnings Multiplier, Recurring Revenue, Liquidation Value, Cash Flow, Market Valuation.
References
- U.S. Securities and Exchange Commission. “Twitter 2021 Annual Report”, Page 58.
- U.S. Securities and Exchange Commission. “Amendment No. 9 to Schedule 13D”.
- Social Media Today. “Challenges Continue at Twitter, with Revenue Down 40% Year-Over-Year”.
