A Primer on Business Valuation
The first step in valuing a business is to determine the purpose and scope of the valuation. This will in turn determine the standard of value used, reporting requirements, audience, and other elements of the project.
The purpose of this business valuation primer is to give you a high level view of some of the important concepts in business valuation.
The next step is to determine which approach to use to determine the value of a business. The three most common approaches are as follows:
Market Approach – Search for comparable business sales in a “comps” database to determine the likely sales price. It usually generates a multiple of earnings based on the subject company’s gross sales, EBITDA or discretionary earnings. It can be a great method if you can find enough comparable sales in the same industry and of the same size as the subject business. This approach does not take into consideration company specific risk/reward elements.
Assets Approach – Can be as simple as adding up all of the assets of the business minus all of the liabilities. Used in situations where the income of the business doesn’t support the value of the assets under management. As an example, the Asset Approach is a fairly common way to value restaurants which are not generating much revenue but have a good lease, assets, tenant improvements, licenses and permits.
Income Approach – A valuation based on the earnings of the company. Typically used when the value of the earnings are in excess of the value of the assets. It should take into consideration all of the elements of value, consideration for a living wage for the owner, and the cash flow needed to support acquisition debt.
Since most of the businesses we sell are valued and sold based on the Income Approach, we’ll focus on this method.
Here is the basic equation:
B=Benefit Stream. The benefit stream is the earnings the owner or the investor derives from owning the business.
R=Risk Rate of Return. An indication of both the upside and risk an owner takes as part of their investment.
There are lots of ways a business owner can characterize the cash flow or financial benefits of ownership. In order to facilitate the comparison of the earnings of one business to another, rules were created to “normalize” earnings. This process is called “recasting financials”. The two most common ways to describe a company’s cash flow for valuation purposes are as follows:
Discretionary Earnings (DE) – The earnings before interest, taxes, depreciation, amortization, Owners’ salary & benefits, and non-recurring/non-operating expenses. Typically used by owner operator buyers.
EBITDA (EBITDA) – Discretionary Earnings minus a fair market wage of a new Owner or manager. Typically used by financial and strategic buyers.
The rules for recasting are beyond the scope of this primer, but you can get a good approximation by just following the definitions of DE and EBITDA above.
Once we calculate the benefit stream the next step is to determine the applicable rate of return for the business risk assumed. It’s educational to go through the process used by larger corporations before discussing small businesses as many of the same principles apply.
Discount Rate is the Fair Market Rate of Return on Investment for the Risk assumed. This rate is determined as follows:
Risk Free Rate of Return (20 years US Bonds) +
Equity Risk Premium +
Size Premium +
Industry premium +
Company-specific risk premium
Duff & Phelps has a reference book where you can look up most of the values used to calculate the Discount Rate based on company SIC or NAICS code.
For our purposes, what is important is to recognize that there is an inherent risk in investing in a company. This forms the basis of the discount rate (Risk free rate plus Equity Risk premium). Size, Industry, and company specific risks further defines the expected rate of return for the subject business.
Capitalization Rate (CAP Rate) is the discount rate minus the long term growth. The lower the Capitalization rate, the better the value, so long term growth can have a significant impact on valuation. Technology companies are a great example of high valuations for high long term growth rates. We generally use the CAP rate as our denominator for the V=B/R value equation.
Multiple of Earnings (MoE) is the inverse of the Cap Rate. There are books available like the Business Reference Guide that you can use to skip the discount rate and capitalization rate calculation process. You can just look up the MoE and times it by either the discretionary earnings or EBITDA, as applicable, to get the sales price. However, these multiples generally do not take into consideration company specific risk/reward factors or growth rates. The multiples are generally applicable only to a small range of business sizes.
So the updated value equation now looks as follows:
Business Value = EBITDA (or DE)/CAP Rat
Business Value = DE (or EBITDA)*MoE
Be careful not to mix up your multiples. A MoE for EBITDA is different than the MoE of Discretionary Earning. If you mix them up, you will not get the correct value of your business.
Once you’ve determined both the benefit stream and the CAP rate / MoE you can plug it into the value equation to get your answer.
If we used multiple approaches to value, we would then reconcile the data to come to a final determination.
The final step would be to generate a report that documents the process used to determine value.
There are other ways to use the income approach to business valuation including discounted cash flows, Weighted Average Cost of Capital and other derivatives. The fundamental concepts of acquiring a benefit stream that has risks/rewards associated with it remain the same.
In concept, business valuation is easy. In practice it can be hard to determine business value correctly. You need to be an expert in the standard of value used, the industry of your subject, the general and local economy, and be knowledgeable about company specific elements of the business which is often a subject of debate. Business Valuation is a science and industry in and of itself.
Hopefully this primer has helped you get a better idea of the process involved. You can play with our free business valuation calculator to give you an idea of what your business is worth. We’ve used the multiple of earnings method as the basis and then modified it to offset weaknesses in that valuation approach. This includes taking into consideration both the size of the business, growth, and company specific elements.
For a certified business valuation you will need to contact a Certified Business Valuation expert, which we don’t do but we do know many good valuation firms.