"Size does not equal profitability." That's what Michael Collins, partner with Building Industry Advisors, stresses in his column about the impact of size and age on a company's valuation.
Two companies with $5 million in EBITDA will be viewed differently by the market if one of them has $50 million in revenue and the other requires $75 million in revenue to achieve the same. The EBITDA margin (EBITDA divided by revenue) is used to determine profitability per dollar of revenue. The higher the EBITDA margin, the stronger the valuation multiple tends to be.
That being said, a greater amount of EBITDA also tends to drive a higher EBITDA multiple. The number of companies in a given size category decreases as the revenue level increases. In the case of any desired good, the price of that good tends to increase as supply decreases. Buyers are willing to “pay up” to gain ownership of a larger chunk of EBITDA.
Owners of small businesses often believe their company has such strong potential that it deserves an EBITDA multiple similar to a larger firm. Unfortunately, this does not usually occur. A small company usually only has a higher EBITDA multiple than a larger company when the small company is unprofitable. In such a case, the company may be acquired based on asset value.
Dividing the asset value by EBITDA can lead to an unusually high EBITDA multiple. However, if the small company were operating profitably, a true EBITDA multiple–based valuation would yield a higher dollar valuation but would be driven by a lower EBITDA multiple. Mixing the asset and EBITDA valuations can produce misleading results.