Business Valuation Methods in a Nutshell

Central to pricing a business is its profitability. Profit stands as the foremost criterion buyers seek and the paramount factor that underpins a business’s valuation.

While other factors may enter the equation, the spotlight remains firmly on one: profit.

Various terms encapsulate profit, including:

• Earnings before Interest, Taxes, Depreciation, and Amortization (EBITDA): The favored term of M&A intermediaries and investment bankers.
• Seller’s Discretionary Earnings (SDE): Ubiquitous among brokers and buyers in broker-involved deals.
• Seller’s Discretionary Cash Flow (SDCF): Previously favored by the International Business Brokers Association, now largely replaced by SDE.
• Cash Flow: A versatile term encompassing various cash flow measures.
• Net Income: Derived by deducting costs from sales, incorporating general expenses, interest, and taxes.

Two primary methods dominate business valuation:

• Method #1 – Multiple of SDE or EBITDA: Multiply the business’s SDE or EBITDA by a designated multiple. For small businesses, common multiples range from two to four times SDE. Mid-sized businesses, on the other hand, lean towards three to six times EBITDA.
• Method #2 – Comparable Sales Approach: This strategy involves meticulous research into prices of similar businesses that have previously sold. Adjustments are then made based on disparities between your company and the comparative counterpart.

Eager for an in-depth exploration? In the ensuing sections, we delve into intricate details surrounding the two primary methodologies steering your business’s valuation journey.

Business Valuation Method #1 – Multiple of SDE or EBITDA

Empower yourself with this systematic guide to valuing your business using the multiple of earnings method:

Step 1: Unveil the Cash Flow (SDE, EBITDA) over the preceding 12 months or your latest fiscal year. This pivotal phase, known as “recasting” or “normalizing” financial statements, involves adding the following to your business’s net profit: depreciation, amortization, owner’s salary, non-cash expenses, non-recurring expenses, and other fringe benefits.

Step 2: Ignite your business’s potential by multiplying its cash flow by the chosen multiple.

For instance: $1,000,000 EBITDA (Cash Flow) x 4.0 Multiple = $4,000,000 Business Valuation

Familiar Multiples
Below, discover prevailing multiples for businesses generating under $5 million in annual revenue:

• Retail businesses: 1.5 to 3.0 (i.e., cash flow x 1.5-3.0 multiple)
• Service businesses: 1.5 to 3.0 (i.e., cash flow x 1.5-3.0 multiple)
• Food businesses: 1.5 to 3.0 (i.e., cash flow x 1.5-3.0 multiple)
• Manufacturing businesses: 3.0 to 5.0+ (i.e., cash flow x 3.0-5.0+ multiple)
• Wholesale businesses: 2.0 to 4.0 (i.e., cash flow x 2.0-4.0 multiple)

Empower your valuation journey with this insightful roadmap to harnessing the multiple of earnings method.

Navigating Business Valuation for Revenues of $5 Million to $100 Million:

Explore the prevailing multiples for businesses generating between $5 million and $100 million in annual revenue:

• Retail businesses: 3.0 to 5.0 (i.e., cash flow x 3.0-5.0 multiple)
• Service businesses: 3.0 to 5.0 (i.e., cash flow x 3.0-5.0 multiple)
• Food businesses: 3.0 to 4.0 (i.e., cash flow x 3.0-4.0 multiple)
• Manufacturing businesses: 3.0 to 6.0+ (i.e., cash flow x 3.0-6.0+ multiple)
• Wholesale businesses: 2.5 to 5.0 (i.e., cash flow x 2.5-5.0 multiple)

Remember, multiples are influenced by the dynamic economic landscape and market conditions. Determining the precise multiple demands experience. However, the guidelines above can serve as a strong foundation to begin your valuation journey with confidence.

Multiples for Larger Businesses

The valuation of most mid-sized businesses commonly falls within the range of three to six times EBITDA. This multiple, however, is not set in stone and hinges on a variety of factors, with the predominant factor being the industry in which the business operates.

Notably, larger businesses command higher multiples, and the correlation is striking:

• Business A: Generating $100,000 cash flow (SDE) annually = Multiple of 3, translating to an asking price of $300,000.
• Business B: Generating $5 million cash flow (EBITDA) annually = Multiple of 5, resulting in an asking price of $25 million.
• Business C: Generating $100 million cash flow (EBITDA) annually = Multiple of 8, reflecting an asking price of $800 million.

The link between cash flow and multiples is direct. With an escalation in the business’s cash flow or EBITDA, the multiple follows suit. Notably, larger businesses are esteemed by astute investors due to their perceived stability, proficient management teams, and reduced reliance on the owner for operational continuity. This straightforward relationship between a company’s size and its multiple finds substantial support in transactional databases and garners consensus among intermediaries and buyers alike.

What is the Difference Between SDE and EBITDA?

The terms SDE and EBITDA are often used interchangeably, albeit with some nuances. In the context of SDE (Seller’s Discretionary Earnings), it encompasses the owner’s or manager’s salary, which is added back during its calculation. On the other hand, EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) deducts a reasonable sum from the cash flow to account for a full-time manager’s compensation in operating the business.

Illustratively:

Net Profit: $1,000,000

Manager’s (Owner’s) Salary: $200,000

SDE = $1,000,000 + $200,000 = $1,200,000

EBITDA = $1,000,000 – $200,000 = $800,000

SDE takes precedence when an individual is considering acquiring your business, as they often intend to personally oversee its operations.

EBITDA, conversely, gains prominence when a corporate entity is looking to acquire your business. This distinction arises from the following rationale:

• Individual buyers typically plan to directly manage the business, obviating the need for a dedicated manager’s salary.
• Companies eyeing an acquisition usually necessitate a full-time manager to replace the existing owner, necessitating a deduction from the available cash flow.

Business Valuation Method #2 – Comparable Sales Approach

The comparable sales approach stands as a robust method for gauging the valuation of your business, leveraging the prices of analogous businesses that have been sold. This involves meticulous adjustments to accommodate any differentiating factors between your enterprise and the subject (comparable) company.

However, implementing this approach can pose challenges due to the non-disclosure of business sale prices in the public domain. This lack of transparency contributes to the substantial range of potential values that a company might command. The primary wellspring of comparable transaction data is typically available through seasoned sources such as business brokers, M&A intermediaries, or adept business appraisers. These professionals wield access to private databases housing the crux of comparable business sales data.

Although a mere three or four databases hold this information, it’s crucial to acknowledge that while resourceful, the data is often incomplete or sparse. Thus, placing exclusive reliance on this data may not be prudent. Collectively, these databases aggregate approximately 100,000 transactions, offering a valuable but nuanced landscape for valuation insights.

Other Factors to Consider When Valuing a Business

Elevating the worth of your business hinges on two key avenues:

1. Amplify Cash Flow (SDE, EBITDA): The first avenue is augmenting cash flow (SDE, EBITDA), achieved through two fundamental methods:

• Trimming expenses.
• Expanding revenues.

2. Elevate the Multiple: The second route involves enhancing your multiple, a factor influenced by various elements such as:

• Risk Assessment: Your multiple reflects the buyer’s perception of risk. Lowering business risks can elevate your multiple and consequently, your valuation.
• Recurring Income: Businesses with steady recurring revenue often command higher multiples.
• Growth Blueprint: Realistic growth strategies can lead to higher multiples from potential buyers.

Accounting for Synergies

The valuation methodologies mentioned earlier do not incorporate potential synergies. Determining synergy value necessitates knowledge of the buyer’s identity and access to their financial statements. Moreover, synergy value is bespoke to each buyer, leading to considerable variations in your business’s valuation based on the buyer.

There are five synergy types: cost savings, revenue enhancement, process optimization, financial engineering (e.g., cost-effective debt access), and tax advantages.

Pricing a Business that’s Losing Money

Let’s consider a scenario: You’ve invested $1 million into a manufacturing business that’s currently breaking even. It might seem logical to assume its value matches your investment, but reality often tells a different story.

Buyers in the market typically explore opportunities across various industries, which implies your business price must align with competitive alternatives available to them.

Note: While this principle may not hold true when a buyer seeks a specific business type, like an IT staffing company, it’s crucial to recognize that a majority of buyers aren’t limited to one industry preference. Thus, we advise against building your business sale strategy around exceptions.

Your business price must rival other investment prospects accessible to potential buyers. Imagine stepping into a buyer’s shoes: Which of these two businesses would you choose?

• Business A: Listed at $5 million, presently breaking even.
• Business B: Also priced at $5 million, boasting an EBITDA of $1,500,000.

Buyers’ Perspective: The choice is evident—almost all buyers would opt for Business B. It’s vital to remember that a business’s profitability, particularly the correlation between the asking price and EBITDA or the multiple, is the foremost criterion buyers consider.

Why do unprofitable businesses end up for sale?

Because they are, indeed, unprofitable.

While these businesses are on the market, it’s important to note that they often remain unsold. Why is there a scarcity of appropriately priced businesses that are still available? The answer lies in those that have already been sold—because they were accurately priced. In fact, a significant portion, ranging from 80% to 90%, of businesses are likely overpriced. Thus, don’t let the existence of overpriced listings mislead your perception of the market.

FAQs

What’s encompassed in the price?

The price ought to encompass every tangible and intangible asset integral to the business’s cash flow generation. This encompasses the full spectrum of equipment and assets essential for the business’s day-to-day operations.

Inclusion of Inventory: A Point of Consideration

The matter of including inventory sparks frequent discussions among experts. You have the option to seek compensation for the inventory alongside the established price. Since negotiations are inevitable, proactively proposing this inclusion can yield insightful outcomes.