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Methods Used to Value Businesses Business valuation plays a key role whether you are selling, buying or investing. It is often the realistic valuation that brings buyer and seller close enough to begin a successful negotiation process. Conversely, an unrealistic valuation can become a barrier to generating interest, and an otherwise strong business may become tomorrow’s “white elephant.” It is important that both buyer and seller have a good idea of how the market values the type and quality of business being looked at. Otherwise, it is unlikely that they will progress to that all-important “zone of mutual interest.”
Strictly speaking, a business is worth what a buyer will pay for it. Business valuation is the mix of art and science that attempts to pre-determine that number up front without going through the negotiation process. While inexact by definition, there are a number of ways to estimate a fair price. We will go through several methods in this section. Some methods are more appropriate for certain types of situations. A recommended best practice is to determine the two, three or four approaches that are most appropriate and use an average or weighted average of the outcomes to arrive at your final valuation.
Table of Contents:
1. EBITDA Multiplier Approach
2. Capitalized Earnings Approach
3. Excess Earnings Method
4. Discounted Cash Flow
5. Rule of Thumb Methods
6. Start-Up Cost Approach
7. Acquisition Debt Value
8. Liquidation Value Method
9. Conclusion
1. EBITDA Multiplier Approach
Many businesses are valued based upon the yearly cash flows they generate. Probably the most widely used of these cash flow methods is the so-called EBITDA Multiplier Method. To determine EBITDA, you take the accounting earnings of the business before interest and taxes and add back non-cash expenses from the income statement such as depreciation and amortization.
Below is an example of how EBITDA is calculated.
| Example | | | Revenues | $10,000,000 | | Cost of sales | 8,000,000 | | Gross profit | 2,000,000 | | General and administrative costs | 500,000 | | Depreciation | 100,000 | | Amortization | 50,000 | | Interest expense | 250,000 | | Total expenses | 900,000 | | Net income before taxes | 1,100,000 | |
| Income taxes (40%) | 440,000 | | Net income after taxes | $660,000 | | Calculation of EBITDA | | | Net income after taxes | $660,000 | | Interest | 250,000 | | Income taxes | 440,000 | | Depreciation | 100,000 | | Amortization | 50,000 | | EBITDA | $1,500,000 |
Usually, EBITDA is then adjusted in several ways. First, expenses that will not be carried into the new business are removed and added to EBITDA. These can be substantial for the closely held family business. Excessive compensation and perquisites may be provided to the owner and his family in order to reduce taxes. Since these are really disguised dividends, they can be added back to EBITDA after reducing their total for the cost of replacing the family with a capable manager paid a market salary. Secondly, some buyers will subtract from the adjusted EBITDA any required yearly capital expenditures.
The adjusted EBITDA is then multiplied by a “times earnings multiplier” to arrive at an overall valuation. Typical multipliers can range from 3 to 6 times adjusted EBITDA, particularly for financial buyers who are buying on a stand-alone basis. Strategic buyers who look to combine the business with existing operations and benefit from synergies might be willing to pay at the higher range. However, the multiplier can go below 3 and substantially above 6, depending upon whether it is a buyer or seller’s market at the time of the sale. Additionally, multipliers above 10 and even upwards to 20 are not unheard of for strategic buyers looking at considerable synergies and the expansion of strong market niches.
Multipliers are popular because they can be derived from historical data on the sale of companies (and possibly because the concept parallels the P/E ratio used so extensively in the public markets). They should not be used in isolation, however, and should be tempered with reality. For example, while public companies in an industry may sell for an average of a 10 multiple, smaller private companies with less market dominance and liquidity can not expect to apply the same multiplier. A comparison with smaller company sales data will have to be made and a cross-check using other methods would be prudent to more reasonably value the smaller company.
2. Capitalized Earnings Approach
The Capitalized Earnings Approach is conceptually similar to the Earnings Multiplier Method. Adjusted EBITDA is once again used as the basis. In this case, however, adjusted EBITDA is divided by a capitalization rate that represents the investors target rate of return. Given that the business is purchased for the resulting value and adjusted EBITDA cash flow is maintained, the investor could expect to make his desired return. Since the impact of a 20% capitalization rate is the same as a 5 multiplier, one might think of the multiplier as the reciprocal of the capitalization rate and vice versa.
To illustrate, let’s look at a hypothetical utility company that has $1,500,000 in EBITDA and capital expenditures of $500,000 per year. Assuming this is a public company, we can leave the owner adjustments out, but a prudent investor might reduce EBITDA for the $500,000 in capital expenditures to arrive at an adjusted EBITDA of $1,000,000. This is a safe, liquid company that should retain its full value over many years.
Let’s further assume that no risk investments such as savings accounts and treasury bills are paying 8% per year. Our prudent buyer might assess the utility at slightly higher risk than these instruments and assign a risk factor of 2% to arrive at a 10% capitalization rate. He would then take the $1,000,000 adjusted EBITDA and divide by his 10% capitalization rate to arrive at a value of $10,000,000 for the business. If buying stock, he would then divide the business value by the number of shares outstanding to determine his target price per share.
In dealing with small, private companies the risks increase. They are often more highly leveraged, barriers to entry are typically lower, and physical assets that could be sold in a downturn may represent a smaller portion of the balance sheet. Further, one must consider their lack of liquidity over relatively short periods of time. As a result of these higher perceived risks, higher capitalization rates are used. Rates of 20% to 25% are not uncommon. That is, buyers will often expect a return on investment of 20% to 25% when buying a small business. The prime determinant will be the level of risk assigned above risk free investments.
3. Excess Earnings Method
The Excess Earnings Method attempts to value separately a company’s asset value and its goodwill value. In this case, excess earnings and goodwill are synonymous, but we are taking literary license from the balance sheet definition of goodwill which is different. Since assets have a value separate from the business and could be sold as such, they are generally valued higher than goodwill. Goodwill is an intangible that could conceivably disappear with changing business conditions or if the buyer is not as adept at managing the business as the seller.
As an example, let’s suppose Mr. Owner runs a petroleum distributorship. His company has Tangible Assets with a fair market value of $1,000,000. Further, let’s assume that he pays himself a market salary – the same amount that he would have to pay a competent manager to do his job. After paying his salary and all expenses, Mr. Owner’s business has earnings of $250,000.
Enter Mr. Buyer who is looking to purchase the business in order to earn a reasonable return on his investment. In order to do so, Mr. Buyer has decided to use the Excess Earnings Method as one of several approaches to value Mr. Owner’s business. First, Mr. Buyer will look to assign a reasonable return on assets to value that portion. In this case, industry return on assets averages 12%. This is also Mr. Buyer’s approximate cost of capital since his business is capitalized by 70% debt at 8% and 30% equity for which he looks to earn a 20% return [(.70 x .08 = .056) + (.30 x .20 = .06) = 11.6%].
In order to complete the first step, Mr. Buyer will determine the amount of earnings necessary to give him this return on the Tangible Assets. Using the industry 12%, $120,000 are derived from the Tangible Assets of the business ($1,000,000 x .12 = $120,000). The remaining $130,000 earnings ($250,000 - $120,000 = $130,000) can then be allocated to excess earnings or goodwill.
The $130,000 excess earnings number is then typically multiplied by a factor of 2 to 5 based on a risk assessment of the business. The higher the factor, the higher the assessed attractiveness of the business. There are many variations of factors and opinions that could be used, but our Mr. Buyer decides to look at five factors: industry growth, market desirability, variability of past earnings, competitiveness and brand quality. He arrives at an average of 3 representative of a solid, profitable company.
Therefore, Mr. Buyer calculates the value of the business as follows:
| A. Fair market value of Tangible Assets | $1,000,000 | | B. Total Earnings | $250,000 | | C. Earnings attributable to Tangible Assets | | | ($1,000,000 x 12% = $120,000) | $120,000 | | D. Excess Earnings | | | ($250,000 - $120,000 = $130,000) | $130,000 | | E. Value of Excess Earnings/Goodwill | | | ($130,000 x 3 = $390,000) | $390,000 | | F. Estimated Total Value (A + E) | $1,390,000 |
The Multiplier and Capitalization methods work best for businesses that derive their earnings primarily from tangible assets (capital intensive businesses). In the case of most small businesses that earn only a portion of their income from tangible assets, the Excess Earnings Method is probably a better approach.
4. Discounted Cash Flow
The Discounted Cash Flow method, properly done, is one of the most complete approaches to valuation and is applicable to all businesses. Its versions are many, it lends itself readily to computer applications and some of the biggest companies (e.g.,ExxonMobil) and most successful investors (e.g., Warren Buffett) are known to favor it.
Under this method, you look at future cash flows from the business and discount them based upon your assessment of time and risk factors or benchmark cost of capital. As with the other approaches, the higher the risk, the higher the discount factor.
The DCF method begins with a forward looking projection of revenues and operating profit. The resulting operating income projections are then adjusted for nonrecurring and nonoperating items of income and expense and are reduced by taxes. This result is then further adjusted by adding back depreciation and amortization and deducting net investments in working capital and capital expenditures.
At the end of a given period, typically five or ten years, a “terminal” or “residual” value is calculated for the business. This value is then added to the discounted cash flows to produce an overall valuation for the business.
Since the residual value is usually a large part of the valuation, care must be taken in how it is determined. The two methods most commonly used to calculate residual value are the perpetuity method and the multiplier approach. The perpetuity method capitalizes the final year’s projected cash flow by a discount rate as if it were and annuity. The multiplier approach applies a multiplier to the final year’s cash flow.
The result of the discounted cash flows and the residual value is the asset value of the business. Net equity value is then determined by deducting the market value of interest-bearing debt and adding the market value of any assets that remain in the business. Below is an example of a Discounted Cash Flow valuation.
| Discounted Cash Flow Valuation (1,000's) |
| Income Line Items | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Terminal Value |
| Revenues | $15,000 | $18,000 | $22,000 | $26,000 | $32,000 | | | EBIT | $2,250 | $2,700 | $3,300 | $3,900 | $4,800 | | Income Taxes
(cash basis) | $810 | $972 | $1,188 | $1,404 | $1,728 | | | Net Operating Income | $1,440 | $1,728 | $2,112 | $2,496 | $3,072 | |
| Plus: | | | | | | | | Depreciation | $600 | $720 | $880 | $1,040 | $1,280 | | | Less: | | | | | | | | Net Change in Working Capital | -$75 | -$50 | -$60 | -$80 | -$85 | | | Capital Expenditures | -$800 | -$850 | -$950 | -$1,000 | -$1,050 | | | Free Cash Flows | $1,165 | $1,191 | $1,982 | $2,456 | $3,217 | $22,979 | | Net Present Value at 14% | $1,022 | $1,191 | $1,338 | $1,434 | $1,671 | $11,934 |
| Total Business Value | $18,610 | | Minus:Market Value of Debt | $11,678 | | Equity Value | $6,932 |
The basis of the calculation is that cash flow five years from now is not worth the same to an investor as current cash flow. Thus, the formula tends to give little value to cash flows that are too far in the future. Also, the calculation is sensitive to the discount rate with higher discount rates resulting in lower business values. Therefore, care should be taken to determine a discount rate that as accurately as possible reflects the projected market risk component above a risk free investment such as treasury bills, or as an alternative, reflects the buyer’s true cost of capital.
5. Rule of Thumb Methods
One of the more common, albeit less exact, approaches to small business valuation is the use of industry rules of thumb. While most financial analysts cringe at the use of these approaches, they are often useful as a cross-check to more well-thought-out calculations.
There are many rules of thumb. Some examples are as follows:
| Internet Service Provider | $75 to $125 per subscriber plus equipment value | | Weekly Newspaper | 100% of one year’s gross income | | Insurance Agencies | 1 to 2 times annual gross commissions | | Real Estate Agencies | .2 to .3 times annual gross commissions | | Restaurants | .3 to .5 annual gross sales | | Travel Agencies | .05 to .1 times annual gross sales | | Convenience Stores | .5 times annual gross sales | | Liquor Stores | 2 times owner earnings plus asset value |
The good news about rules of thumb is that they can be derived from actual historical sales. They are also usually easy to calculate. The bad news is that they are representative of the average business sold. So it is recommended that they always be tempered with judgment and used in conjunction with other methods.
6. Start-Up Cost Approach
A buyer may sometimes purchase a company just to avoid the time and difficulties involved in starting from scratch. H/she may first start with his projected costs based on his or her own business plan. Next h/she will look at your business and analyze what it may be missing relative to the buyer’s start-up plan calculating value based on his or her projected costs to organize personnel, obtain leases, purchase fixed assets and cost to develop intangibles such as supplier agreements, licenses copyrights, etc.
A reasonable premium above the buyer’s plan may be assigned because of the time and effort that will be saved. The more difficult, expensive and time consuming the start-up is likely to be, the higher the premium assigned and, therefore, the higher the valuation based on this approach.
7. Acquisition Debt Value
The minimum value a business should bring is the higher of our last two methods: 1) its Acquisition Debt Value or 2) its Liquidation Value.
If your business produces positive cash flow (EBITDA), that positive cash flow can service (that is, pay interest and principal) a certain amount of acquisition debt for the buyer. The amount of acquisition debt so serviced is the minimum value for your business, particularly to a financial buyer.
For example, assume a cash flow of $200,000 per year. If that cash flow is sufficient to pay the interest and principal on $1,200,000 of bank debt maturing over a five-year loan term (exclusive of the balloon principal payment in the fifth year which can be refinanced), the value of the business would be $1,200,000, particularly to a financial buyer.
There is a limit to the amount that senior lenders will provide without buyer equity and cash coverage ratios sometimes limit the amount of debt. Thus, once that debt limit is reached, the buyer will have to put up equity and/or cash flow must be sufficiently high to attract outside equity investors.
8. Liquidation Value Method
Some businesses are worth only the liquidation value of their assets. Liquidation refers to the price that would be received in an orderly liquidation, not in a fire sale. These are typically businesses that are not producing positive cash flow and do not have prospects of doing so.
9. Conclusion
There are diverse methods to value a business for sale or purchase. Some methods discussed above are more suited to certain industry classifications and types of buyers. Further, the variables and assumptions involved can heavily influence outcome. The more accurate the assessment of value, the more likely the buyer or seller will have a favorable outcome. It is, therefore, critically important that both the “buy” and “sale” process begin with the most accurate assessment of value possible. That is why I include an objective and thorough assessment of value as part of my basic client service.
If you are planning to sell your business within the next few months, simply click on On-Line Analysis at the bottom of this page and complete the information requested. After review, I will then contact you with the business value you can expect through a properly conducted marketing campaign.
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