Why relying on historical precedent transactions can be misleading and how to use a more relevant metric based on growth and profitability.

When it comes to valuing your company, you might be tempted to just look at the industry benchmarks and see how much similar companies have sold for in the past. This can give you a sense of the market demand and the price range for your business. However, using industry-specific precedent transactions as the sole basis for your valuation can also be misleading and inaccurate. In this blog, we will explain why industry benchmarks have their value and limits, and how to use a more relevant metric based on your company's growth rate and profit margin.

The Value and Limits of Industry Benchmarks:
Industry benchmarks are helpful to set the broad outlines for valuation in specific industries. They can show you the average multiples of revenue, EBITDA, or other financial metrics that buyers have paid for similar businesses in the past. They can also indicate the trends and cycles of the market, and how different sectors perform relative to each other.

However, using industry benchmarks as the sole basis for your valuation can also have several drawbacks. Here are some of the inherent limitations of using historical precedent transactions:

• Limited disclosed financial metrics: Most precedent transactions are based on publicly reported data, which often does not include the full details of the deal structure, the financial performance, or the growth potential of the acquired company. This can make it hard to compare the quality and value of different businesses, and to adjust for any synergies, earn-outs, or contingencies that might affect the final price.
• Data population size and comparability: Depending on the industry and the time period, there might not be enough precedent transactions to draw meaningful conclusions from. Moreover, not all transactions are comparable, as they might involve different types of buyers (strategic vs. financial), different sizes of companies (large vs. small), different stages of development (mature vs. emerging), and different business models (asset-heavy vs. asset-light).
• Economic cycles and acquisition types: The valuation of a company can vary significantly depending on the economic conditions and the type of acquisition. For example, during a recession, buyers might be more cautious and pay lower multiples, while during a boom, they might be more aggressive and pay higher multiples. Similarly, the valuation of a company can differ depending on whether it is a standalone acquisition, a merger, a spin-off, or a carve-out.

A More Relevant Way to Value Your Company:
Given the limitations of using industry benchmarks, a more relevant way to value your company is based on its combined growth rate and profit margin. This metric, also known as the Rule of 40, is widely used by investors and analysts to evaluate the performance and potential of software and technology companies. The Rule of 40 states that a company's growth rate plus its profit margin should be at least 40%. For example, if a company has a 20% growth rate and a 20% profit margin, it meets the Rule of 40. If it has a 30% growth rate and a 10% profit margin, it also meets the Rule of 40. However, if it has a 10% growth rate and a 10% profit margin, it falls short of the Rule of 40.

The Rule of 40 is based on the idea that a company should balance its growth and profitability, and that a trade-off between the two is acceptable as long as the sum is above 40%. A company that grows faster than its profit margin can justify its high valuation by its future potential, while a company that has a higher profit margin than its growth rate can justify its high valuation by its current performance. However, a company that has a low growth rate and a low profit margin is likely to be undervalued by the market.

The Rule of 40 is not just applicable to software and technology companies but can also serve as a general operating metric for any company operating in a high-growth, high-margin industry. This metric allows businesses to assess their performance in a balanced manner by correlating growth rate with profit margin. When generalized across industries, the Rule of 40 offers a broad framework that helps companies understand how well they are harnessing their growth potential while managing profitability.

More generally, comparing a company's specific metrics to industry averages can provide a relative valuation metric that accounts for sector-specific economic conditions and performance standards. For instance, if a company achieves industry-average growth rates and profit margins—such as a 15% growth rate and a 20% profit margin—and the industry average EBITDA multiple is 10x, its valuation should be consistent with the industry average. This direct comparison to industry averages allows the company to position itself relative to the broader industry valuation. Conversely, companies deviating from these averages might adjust their valuation multiples accordingly; a company with a 15% growth rate and a 30% profit margin might justify a higher multiple, due to its higher profitability, while one with both a 10% growth rate and a 10% profit margin might see a reduced multiple, reflecting its lower performance relative to industry standards.

Conclusion:
Valuing your company is not an exact science, but a combination of art and science. You need to use both quantitative and qualitative factors to assess your company's worth and potential. Industry benchmarks can be useful to set the general parameters for your valuation, but they can also be misleading and inaccurate if you rely on them too much. A more relevant way to value your company is based on its combined growth rate and profit margin, which reflects your company's performance and potential relative to industry averages. By using this metric, you can improve your understanding of how to estimate the appropriate valuation multiple for your business.

If you have questions or would like to know how companies in your industry are valued, please reach out to me here.