If you own or manage a plastics business, you're surely curious about its value in today's markets. Because mergers and acquisitions are a topic of nearly universal interest right now, I'm often asked, ``What's the multiple?'' But is that the right question?
The value of a business is typically calculated by multiplying annual free cash flow (Earnings Before Interest, Taxes Depreciation and Amortization, or EBITDA) by ``x,'' with ``x'' being the multiple. But ``x'' itself depends on the quality of the earnings themselves. So, the real questions - the right ones to ask to determine value - are about the quality of earnings.
What is the quality of your earnings?
This simple question goes to the heart of your business. Earnings are ``good'' when they're growing and sustainable. Strong margins are good, but buyers of a business look forward, not backward, so ``sustainability'' is judged by future growth and margins.
Here are other questions that expose ``quality'' in earnings.
How strong is your market position? Relying on one customer is typically not good; having a broad, deep, and stable base of customers generally puts you in a much stronger position.
If competitors are willing to sell items at cost or below to utilize capacity, that's typically bad; competitive advantage is always good. If, for example, you try to raise prices 5 percent to pass through a resin cost increase, do your customers leave immediately? If so, then they don't place a high value on your products or they can easily source them elsewhere (perhaps through the dreaded reverse auction).
Are your customers and end markets growing? Some forces at play here are external; others are under your control. If an industry is growing - today, for example, pharmaceuticals or oil - plastics companies serving those industries will also likely be stable and growing (a rising tide floats all boats). If you sell products to a customer that's successful in a stable, flat industry, that's probably OK, too. For example, some original equipment manufacturers in the auto industry are doing well; most are not.
If your product is fundamentally important to a customer's core business - say, a component in an innovative, promising product line - those earnings likely have good growth potential.
Addressing future trends and technology can also generate high-quality earnings and higher multiples. For example, in packaging, the Holy Grail right now is low-cost, functional, environmentally friendly plastics. Wal-Mart is requiring this of its suppliers; if your product helps put your customers' products on Wal-Mart's shelves, that should be good.
If your business is growing, what is its capacity? If your factory is bursting at the seams and equipment is running at near capacity, then any growth will require capital, potentially significant capital. If you have to buy $10 million in equipment to take on an additional $1 million in business, that's usually not good. A lack of capacity for growth can negatively impact earnings quality and value.
Capital demands are a fact of life in the plastics industry. A business that demonstrates a track record of growing earnings while managing capital expenditures is obviously attractive. Along the same line of thinking, it's probably not a good idea to squeeze every bit of juice out of your business just before a sale. Let's say you put 30 percent of earnings back into the business annually. If you're planning to sell, it's tempting to put that money aside and hold the business together with string and rubber bands for a while. But most buyers conclude that suspending investment reduces the quality of earnings.
``How can we improve the quality of our earnings?'' If you plan to sell your business in a year or two, start looking for ways to increase the quality of its earnings - today's and tomorrow's. This is not about smoke and mirrors or pulling a rabbit out of a hat. It's about careful planning, strategy, and execution.
By the way, in the plastics industry, average multiples have historically ranged between 5 and 7.5, depending on earnings quality. Right now, the market is strong and the multiples being paid are typically ranging between 6 to 8.5. But remember, your ``x'' factor depends on the quality of your earnings.
Will Frame is a managing director with Deloitte & Touche Corporate Finance LLC.