Valuation Multiples in IT Services

Introduction 

M&A activity in the IT services sector has been picking up in recent years with several high-profile deals taking place. This has led to increased scrutiny of valuation multiples in the sector. This blog post will introduce the most used valuation multiples in IT services and how they have evolved in recent years. 

What are Valuation Multiples 

When analyzing an investment, one of the first things an investor will look at is the company's valuation multiple. This is simply a way of expressing the value of a company as a multiple of its earnings or revenue. For example, if a company is valued at 10.0x its earnings, that means it would take 10 years of earnings to equal the value of the company. 

In M&A, multiples are typically used to express the company's valuation for internal analysis or to structure an acquisition offer. However, it is essential to remember that valuation multiples are just one tool in the valuation toolbox and should not be used in isolation. Other valuation methods, such as discounted cash flow, can also be used to arrive at the target's final price.  

Introduction to IT Services 

When valuing a business, investors typically put a premium on companies that possess unique technical expertise and operate in a high-growth industry. This is common practice among IT services as they benefit from ongoing secular digitalization tailwinds. As a result, companies in this space typically have higher valuation multiples than other businesses.

This premium price can present a challenge for potential buyers, who must be able to justify the purchase price with future earnings growth. However, for sellers, the high valuation multiples can provide a nice windfall if the deal goes through.  

It is important to remember that not all IT services companies are the same. Factors such as company size, growth, and profit margin will affect the valuation multiple that potential buyers are willing to pay. As such, it is essential to understand what determines valuation multiples of IT services companies as optimizing the relevant metrics can meaningfully improve the exit valuations.  

EV/EBITDA multiple in IT Services 

The EV/EBITDA multiple is the most common valuation multiple used in the IT services sector. The acronym EV/EBITDA stands for enterprise value to earnings before interest, taxes, depreciation, and amortization. This multiple provides a normalized ratio, excluding the differences in capital structure, taxation, and fixed assets. In other words, EBITDA accounts well for the difference in the operations of the analyzed companies. 

Aventis Advisors, an M&A advisory firm, conducted a study of IT services valuation multiples. Among 280 IT services deals in the sample, for which the EV/EBITDA multiple was available, the median EV/EBITDA was relatively stable in the last seven years – moving in the range of 10.0x – 12.5x. Variability among the quartiles was also minimal, especially among companies trading at lower multiples.  

EV/Revenue multiple in IT Services 

Revenue multiples are not commonly used for IT services, but they can be a helpful valuation method in specific scenarios. EV/Revenue can be a suitable alternative to EV/EBITDA when the analyzed company does not have a normalized profit level or operates with negative EBITDA. Also, revenue multiples are more commonly disclosed in private transactions. 

When using revenue multiples to value a company, it is vital to consider the quality of the company's revenue alongside its growth. Companies with a high recurring revenue base and stable growth typically receive higher valuations in the long term than names with fast-growing but low-quality revenue.  

Aventis Advisors in the same report looked at 466 IT services deals that took place over the past seven years for which EV/Revenue multiple was available. Like the EBITDA multiple, the median revenue multiple stayed stable for most of the period analyzed. The exception was the pandemic-led dip in 2020 and the swift recovery the following year as work went virtual. IT services benefited from the increased investment in digital transformation by businesses.    

Summary 

IT services are a diverse industry with plenty of differences: boutique companies compete for clients and talent with more prominent players. Some companies provide a wide range of services, while others build their business around niche solutions. This makes it complicated to get an exact valuation multiple estimate for an "average" IT service provider. Still, observing how valuation multiples have changed over time and the drivers of those change can be useful for anyone planning to do an M&A transaction in this industry.