Funeral home appraisal, funeral home valuation, cemetery appraisal, cemetery valuation

Multiples and how they are chosen

For the past 20 years Funeral Home Values have been expressed most often as a multiple of EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization).  It was not always so.  Prior to the 90’s values were often expressed as a multiple of revenue.  The most common “Rule of Thumb” being 1.7 to 1.9 times Net Revenue.

Regardless of how value was expressed the fundamental drivers were the same:  Future cash streams discounted to a present value.  In fact, if you know how to price bonds you understand the theory behind valuing a business.  Very simply, if I have $XX to invest today what is a “risk-relative” cash return I can expect in the future.  The lower the risk the lower the return and, conversely, the higher the risk the higher the return.  Businesses, especially closely held businesses, are believed to represent higher risk than investing in US Treasury Bonds.  In fact, US Treasury Bonds are most frequently used as a basis for what is known as a “Risk Free Rate.”

So, what is a multiple?  It is a convenient number representing the reciprocal of what is termed the Capitalization Rate.   A multiple of 5, for instance, is the equivalent of a 20% Capitalization Rate or Cap Rate.  (1 / 5 = 20%)  Likewise, a multiple of 4 is equal to a 25% Cap Rate and a multiple of 6 is equal to 16.67%.  The higher the multiple the lower the Cap Rate and the lower the multiple the higher the Cap Rate.

How are Cap Rates determined?

As the factor used to determine the present value of future cash flows, Cap Rates are proportional to the presumptive risk attached to those future cash flows.  Starting with the US Treasury Rate as the “Risk Free Rate” an assessment is made relative to anticipated risk for the investment under consideration.  Despite the relatively pseudoscientific rationalizations for determining a risk premium, this is really a matter of judgment, experience and recent sales of comparable investments (what the market is currently paying).

Risk is the critical factor.  A very small firm in a limited market with new competition and recent market share loss is a higher risk than a large firm in a metropolitan market with growing market share.

For those funeral homes that are salable, current multiples range from a low of 4 to a high of 6.  Higher multiples, however, are seen for “mega” firms with strong management in place and high regional brand equity.  These multiples may reach a high of 8 times EBITDA.  Of course, this applies mostly to privately held firms.

Final note:

The Capitalization Rate should not be confused with either a Return on Investment (ROI) or the more complex but far more accurate Internal Rate of Return (IRR).  The Capitalization Rate is simply the rate at which future cash flows are discounted in order to determine Gross Value.

Next week: What is EBITDA and how to calculate it?

Disclaimer:

While I have experience in business valuation, I am not a Certified Business Appraiser.