Prices Level Off For Middle Market Companies.

Having increased an average of 35 percent from 1993-97, the prices paid for middle-market U.S. companies have been comparatively stable during the last 30 months, according to a survey by IMAP/Mergernetwork.com. The most notable exceptions: manufacturers in the technology sector and companies selling to aggressive corporate consolidators or private equity groups doing strategic build-ups.

The survey results compare the multiples of EBIT (earnings before interest and taxes) paid for various sizes and categories of middle-market manufacturers (see accompanying table). EBIT was selected over EBITDA (depreciation and amortization added) because it has been more widely used historically. EBIT was calculated as trailing 12 months' earnings before interest and taxes, adjusted for nonrecurring expenses and discretionary owner distributions, including compensation in excess of market rates. Seller notes and similar items were discounted to present values. To compute the multiple, one divides the purchase price plus the assumption of any interest-bearing debt by the adjusted EBIT.

The study produced three clear findings. First, there is a significant differential in multiples paid for larger vs. smaller companies. Second, non-proprietary low-to medium-technology manufacturers sold for higher multiples than proprietary manufacturers. Third, technology companies sold at a premium to all companies. Moreover, public companies command higher multiples than private ones, and the liquidity of a public company increases its selling multiples.

Larger companies typically sell for higher multiples because they tend to have stronger market positions, greater management depth, a more diversified base of business and better access to capital. Recently, in the rush to gain critical mass and go public, buyers further bid up the prices of larger middle-market companies whose acquisition would shorten the process.

Manufacturers of proprietary products have long been preferred acquisition targets for private equity groups and operating companies alike. However, that preference does not automatically translate into a higher selling multiple. The key to a high multiple is the anticipated future cash flow.

In explaining the higher multiples given to high-tech firms, the survey's authors cited several factors. First, technology companies are typically in market segments that are growing much faster than non-technology companies. Second, publicly traded technology companies have had price-to-earnings ratios well above the S&P 500 average and can afford to pay high multiples for acquisitions that will still be accretive to their earnings. Third, the acquisition of smaller technology companies can bring larger companies such advantages as strong patent positions, intellectual capital, lower costs and faster time-to-market alternatives than their own internal development.

Some additional insights into the effects of technology on valuations can be gained by considering public companies, as shown in the table at left. The measure used is the ratio of the Market Invested Capital (value of the outstanding stock plus the interest-bearing debt) divided by trailing 12 months of EBIT (MIC/EBIT).

NASDAQ Firms         Data for 12 mos.            Data for 12 mos.
                     ending 3/99                 ending 3/00
                     # of Firms       MIC / EBIT # of Firms       MIC / EBIT
All Firms            1,094            14.0       898              15.1
Firms w/o Technology 817              13.0       706              13.4
Technology Firms     277              16.9       192              21.3
Source: Market Guides