Sell
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Step
2 - Business Valuation
Business
Valuation Model
The Multiple Of Earnings Method
The
multiple of earnings method is one of the simpler ways to value
a business - you take a company's profits times a certain multiple
and arrive at a value.
But
even with this simple method, there are endless ways to vary
the outcome: do you use past profits or projected
future profits? Before or after taxes? How do you choose the
multiple? Would you be better off using a method that multiplies
the sales instead of the profits?
Let's
discuss all of these issues.
Which
Earnings Do You Use?
If
you are going to convince a buyer to choose your business over
all the other businesses on the market you have to appeal
to her motives. Setting your price range based on your actual
profits makes the most sense to buyers . It directly addresses
their main concern - how much money the business makes!
In
the last section we discussed Recasting
Financial Statements.
If done correctly, recast financial statements accurately reflect
the true value the business provides for the owner.
So,
always use your recast financial statements when doing
your valuations.
Specifically,
you should use the "Owner's Benefit" or "Seller's
Discretionary Cash Flow".
Tha
equation for coming up with your Owner's Benefit is:
Annual
Pretax Profit + Owner's Salary + Owner's Perks/Benefits + Interest
+ Depreciation.
This
number will tell the buyer how much cash the business produces
for it's owner on an annual babsis.
You
can use an average of your last 3 years Owner's Benefit.
You
may be tempted to use just the profit from the most recent
year instead of the last three. I recommend you use three
years because that creates more credibility with the buyer.
Especially if your most recent year has been significantly
better than any previous year, the buyer may regard it as
a fluke or even worse - they may suspect you have manipulated
the numbers.
If
your profits have been trending up for each of the last three
years you should consider weighting the more recent years more
heavily. For instance, instead of adding up your profits from
the last 3 years and dividing by three, you can take 70%
of you most recent years profits plus 20% of the prior year
plus 10% of the year before that.
What
About A Multiple Of Future Earnings?
Buyers
are paying for the opportunity to benefit from your company's
future profits, so basing your valuation of projected future
earnings can make sense.
Of
course, the future is impossible to predict perfectly so buyers
are hesitant to pay based on unproved future earnings.
If
your profits have been trending up for the past 3-5 years,
projecting that same rate of growth into the future and then
applying a multiple to that projected profit is a valid way
to go. But don't just rely on your balance sheet. Show the
buyer, in as much detail as possible, how the growth can
continue - even increase.
As
stated before, you want to come up with a range of possible
prices for your business so I suggest experimenting with
all three of the options listed above as we move on to the next
step: using just the most recent years earnings, averaging the
last 3 years of earnings and weighting the last 3 years 70/20/10.
Side
Bar
Be
careful: when basing your price on future earnings you
must fair. An all too common mistake I see people make is that
they set an asking price based on the business' potential: what
the business could be worth if the new owner made
all sorts of changes/improvements such as increasing the marketing
budget, expanding the operation's hours, offering new product
lines or opening new locations.
If
a buyer makes any of these changes, it is extra risk
and investment they will have to take on in addition
to paying for the business itself - you shouldn't price the
business as if these changes are already in place and proven
successful.
Times
What Multiple?
Now
comes the most difficult question of all:
By
what number do you multiply your earnings figure?
Much
of what has been written on this subject states that most businesses
are sold with a multiple that ranges from 2-5.
But
in truth, businesses that sell for 4 or 5 time their EBIT are
rare.
That's
not to say you can't sell your business for that amount, but
in my experience the vast majority of businesses
sell for a figure much closer to 2 or 3.
In
keeping with our theme of finding a range of prices,
I suggest determining a range of multiples. Start with 2.5 and
use the list of Factors
That Affect The Multiple to adjust the multiple up and
down based on your specific situation.
Industry
Rules Of Thumb
A
"Rule Of Thumb" is the most general way to ball park
the price of a business. They are so general in fact
that the may be of no help at all in your particular case.
Add
to that the fact that most industries have more than one
rule of thumb that is used. In the hair salon industry for instance,
I came across 4 different rules of thumb on just one
industry web site:
• 1 times annual adjusted earnings.
• 4 times monthly gross sales PLUS inventory.
• 25-35% of annual gross revenues PLUS fixtures, equipment
& inventory.
• 10-25% of annual adjusted earnings PLUS $2000 per station.
If
you own a salon and apply all 4 of these rules to your business
you may come up with 4 wildly different values for your
business.
If
your industry has one widely accepted rule of thumb you may
want to use it as a starting point. But as you can see,
none of the hair salon examples take into account any of the
factors that are unique to a business - such as the lease, the
quality of the employees or recent trends in earnings.
So
the rule of thumb is just a starting point and you will have
to adjust the multiple up or down based on your unique
circumstances and how you compare to other hair salons.
Knowing
your industry's rules of thumb can be helpful though. Applying
them to your business will at least let you know how realistic
you are being in your pricing.
Also,
they can be helpful in instructing unreasonable (or uneducated)
buyers who make unrealistically low offers on your business.
If you can show them how your pricing is in line with industry
standards it can help them to move off of their low-ball offer.
What
About A Multiple Of Sales?
Basing
the asking price on sales is common in some industries. Most
of the rules of thumb in the restaurant industry, for example,
are based on a multiple of sales. Businesses with few assets
and service or sales based businesses like insurance agencies
or PR firms will often use a multiple of sales.
While
using a multiple of sales may be standard practice in your field,
it doesn't directly address the concerns of the buyer - who
wants to make money. Two similar types of businesses
with exactly the same amount of sales may have nothing in common
when it comes to profits.
Remember:
the buyer can only buy a company if it generates enough cash
flow to pay themselves a decent salary, service their debt and
have enough money left over to expand the business.
So
even if you use a sales-based valuation because that is the
norm in your industry, the buyer will still evaluate your business
and your asking price based on earnings.
Sell
Your Business Tips, Hints & Techniques:
Enter
your name & e-mail address below and each week I'll send
you detailed tips, facts, resources & ideas you can use
right away to help sell your business faster and for more money.
NEXT:
Factors
That Affect The Multiple
