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One of the first questions a business owner has when considering selling his/her business is, “What is my business worth?"

The reality is that determining the value of a business is anything but a simple question and there are many ways to determine an opinion of value (approximately 40).

Valuing a Business using Rules of Thumb

One of the simplest methods used is also the most unreliable – Rules of Thumb.

Most industries have commonly used rules of thumb for providing an opinion of value. They are generally multiples of a certain cash flow – earnings before interest and taxes, shareholders discretionary cash flow and annual sales.

Here are some examples taken from the “2003 Business Reference Guide”: 1. Accounting firms - one times prior years billings 2. Landscape contractors – 1.5 times shareholder discretionary cash flow. 3. Contract manufacturers - 3-5 times earnings before interest, taxes, depreciations and amortization. 4. All (from a database of 3,800 sold businesses) - 44% of annual sales.

Rules of thumbs are actually just the historical averages of completed sales. One manufacturer may have sold for 1 times earning and another for 9. The average is 5 but does it really tell you what an individual business is worth? They are not very accurate and are never used by professional business appraisers to value an individual company.

Consider a very simple example of why rules of thumb are not a good value indicator. Company A has $10,000,000 in sales but loses money and Company B has $10,000,000 in sales but “earns” $1,000,000. If the rule of thumb for this industry were 1.5 times sales, would you pay the same price for both?

Many rules of thumbs are also ranges. Look at the third example where a contract manufacturer sells for 3-5 EBITDA. If your company has an EBITDA of $400,000 is it worth $1.2M or $2.0M? That is a pretty wide spread.

A rule of thumb may provide you with a broad estimation of how much your company may be worth (you can use example number 4) but it should not be the basis for what you will sell a business for

Valuing a Business using Earnings Multiples

Before looking at the different methods and issues it should be pointed out that business valuations have various uses.

Some examples include valuations for divorce or partnership disputes, estate planning, tax assessments, insurance, commercial lending and by a buyer looking to acquire a business. Each may use a different formula and arrive at a completely different number.

There are 39 ways or variations to determine a businesses’ value. From a business sale standpoint, valuing a business is always done through the eyes of the buyer (investor).

In the broadest sense, buyers will value the investment (the business) using an asset approach or by using an Earning Multiple on a cash flow stream.

An Earning Multiple (E.M.) is the inverse of Return on Investment (ROI) and the same as Price Earnings (P/E) ratios used in analyzing public companies. A 20% ROI is equivalent to an EM of 100/20 or 5.

A $1,000,000 investment that earns $200,000 annually has an ROI of 20%. A $200,000 earning stream at a 5 times E.M. has an investment value of $1,000,000. This is pretty simple stuff, or is it?

When it comes to valuing an operating company, there are two big questions. What earnings or cash flow stream is used and what earning multiple is appropriate?

There are several cash flows that could be used – net earnings as stated on the financial statements; earnings after adjustments for discretionary expenditures; earnings before interest; earnings before interest and taxes; earnings before interest, taxes, amortization and depreciation; earnings before interest, taxes, depreciation, amortization and excessive capital expenditures; shareholders’/owners’ discretionary cash flow; etc.

Two of the most common measures are EBITDA and SDCF (shareholders discretionary cash flow). The first measure is generally for larger businesses and SDCF is for smaller businesses.

A further complication in valuing a business using an E.M. is the selection of the timing of the earnings. Is it the most recent years earnings, an average of historical earnings or the average of the future projected earnings (discounted to the present value).

From a buyer’s standpoint, they should only be interested in what future earnings the business can make for them. The past and present will help to forecast these earnings but they will not pay for how successful the business was in 1998.

Of course projecting the future earnings success of a small business is no simple matter.

Once a satisfactory earning stream chosen, a buyer will need to select what earning multiple is appropriate for the investment. This becomes a bigger challenge.

Buying a privately owned business would offer significantly more risks than real estate, treasury bills or investing in a blue chip, publicly traded company. For this reason a buyer will require a better potential ROI (or lower E.M.).

Our July newsletter will address some specific factors that affect the E.M. (including buyer types). A starting point for a buyer will likely be to view other business transactions of comparable companies to establish a historical E.M. range. For privately held companies, this data is not readably available unless you have access to someone in the mergers and acquisitions field.

If this information is available, a buyer could start by gathering the data on businesses that have been recently sold, similar to the one of interest to them. This could be by Standard Industrial Codes (SICs), similar company size, geography, etc.

At the completion of that research, an E.M. range should be determined. It is not uncommon in this research to find E.M. ranges from 0 to double digits.

For illustrative purposes only, lets assume the research uncovered transactions that had E.M. ranging from 2 to 5 times EBITDA. The buyer would likely compare the business in question to these using a variety of matrices to determine whether it is a better, same or weaker business (investment). If it turned out to be a very average business, the E.M. they may end up using to base their offer could be 3.5 times EBITDA.

Remember, this is very simplistic first step. Many other factors are analyzed to arrive at a value the buyer will start to negotiate at.

Factors affecting earning multiples and a final selling price

What factors will a buyer consider when settling on a number (earning multiple).

A first consideration would be how the business in question compares to industry peers. A financial analysis may include a comparison of ratios such as debt/equity, sales/employee, ROE, inventory turns, age of receivables, gross margins, etc.

A non-financial comparisons (to industry peers) would also be performed and include things like production capacity, customer base, personnel, IT infrastructure, age of equipment, supplier contracts, location, intellectual property, etc.

The second major impact on the selection of an earning multiple is how risky the buyer perceives the future earnings. Since an earning multiple is the inverse of return on investment (ROI), the bigger the perceived risk of the investment, the better ROI the buyer will want and hence a lower multiple will be used in the valuation.

Factors affecting the risk include outside influences and internal uncertainties. These could include interest rates, the economic outlook, the industry outlook, legislation, competition, political stability, global instability, dependence on a few customers, how much of the business is repeat business, how liquid the business is and what the impact will be when the existing owner is no longer involved.

These first two factors are likely secondary to the impact the buyer type has on the multiple. Peter Drucker once said, “The buyer rarely buys what the seller thinks he’s selling”. This is very much true when it comes to selling businesses.

Buyers could be categorized into 3 main types – Investment, Employment (job seeker) and Synergistic. Each will have different buying motives and therefore value the business differently (use a different earning multiple).

An investment buyer will generally pay the least for a business as they will strictly look at a ROI – what can they make on this investment versus another and how risky is it versus another. It is a simple risk-return analysis.

An employment buyer is also looking at ROI but will consider the total earnings for them personally versus just the operating company (earnings plus salary/bonuses). Other motivators, besides money may also come into play (they may need for a job, a new challenge, prestige, etc).

The best buyers, from the seller’s standpoint are the ones where there is a synergy in the two businesses coming together. A ROI analysis will take place but a synergistic buyer may be more interested in “acquiring” intangibles - customers, processes, people, a new market, intellectual property, etc. The earning stream of the self-contained business may not be that relevant.

They may also look at the business against the cost to duplicate the establishment of their own facilities, employees and customers. How much would it cost them to establish what is already in place? The buyer would be using a “cost” approach to valuing the business.

A synergistic buyers’ financial analysis should be based more on the contribution the acquisition makes to its earnings through an analysis of what facilities, equipment and labour may be redundant when the two companies become one. If this is the case, a completely different earning stream will be used.

Determining a business value using earnings multiples initially seems straightforward and simple. The truth is that while valuation methodologies are important to get an understanding of the investment value of your company, the final selling price will be more dependant on obtaining the best buyers – synergistic ones.

Asset Approach to Valuing a Business

There are occasions when the earnings of a company are low or negative. If a multiple of earnings were used to determine the value of such a company, a buyer would not pay anything for it.

When low, negative or uncertain earnings exist in a company, an asset approach to determining its value will likely be used.

There are two asset classes that need to be considered - hard or tangible assets and goodwill or intangible assets.

Tangible assets would include items on the balance sheet – inventory, accounts receivable, equipment, fixtures, etc. A buyer is most likely to adjust the stated value of these assets to a “fair value” (the amount at which an asset could be bought and sold between willing parties).

For equipment, there are many different ways of doing an appraisal because the value is affected by whether it is new or used, installed or crated, and its overall condition. For instance, a brand new printing press may cost ten times more than a used press, but to move and install a used press may cost many thousands of dollars.

Estimating the value of equipment can be very specialized, depending on the type of business. A qualified equipment appraiser is often required.

An equipment appraiser will assess the type and condition of the equipment, and its availability in a “used equipment” marketplace to provide a fairly accurate look at its value. There are generally three values to consider. These are the in-place-in-use value, the orderly liquidation value; and the auction value.

Inventory and accounts receivable will also be adjusted from the stated value on the balance sheet. A buyer will consider how saleable the inventory is and how collectible the accounts receivable are and discount them accordingly.

Depreciation is also a consideration for an adjustment, usually in the sellers' favour. A great example is real estate in the business. While real estate typically appreciates, it is depreciated on the balance sheet and does not represent its “fair” or “market” value.

Other assets may have been written down quicker than their replacement value or perhaps even incorrectly expensed versus capitalized. Computer equipment and leased equipment to a fixed dollar value are two examples.

A final adjustment to explore, are the leased facility. If the current property lease is above or below current market values, an adjustment is likely. An example would be a lease with four years remaining at $7 per square foot when market values are $15. The buyer will receive a leasehold benefit of $8 per square foot for four years (discounted to a present value).

Goodwill is the intangible asset that is more difficult to appraise. In the business world, goodwill is the amount that a purchaser is willing to pay over and above the actual dollar value of a company’s tangible assets.

Goodwill can be looked at as the ability of a company to generate profits in excess of those profits required to provide a reasonable return on capital invested. Many things such as the company’s established clientele, its length of time in business, any intellectual property, contracts, or even proprietary processes can affect the amount of goodwill that a particular company has.

A prudent purchaser will look very closely at the last three to five years of financial results and will carefully scrutinize and assess the future prospects of the business before determining the value of the goodwill they are prepared to pay.

If the earnings of a company are nil or negative, the value of goodwill to a buyer will become very subjective. The thought process may be “if the company does not make any money, what value does a customer base or process represent?”

Just like in earning multiple approaches to valuing a private company, the buyer type and their motivations to make the acquisition will have more to do with the final selling price than the valuation methodology chosen

© 2005 Douglas Robbins 
Doug has over thirty years experience as a consultative business intermediary specializing in the sale of mid-sized privately held companies in Canada and the USA. In that time, he has gained the trust of business owners and advisors with his approach and his firm grasp on the complexities of buying and selling a business.