Learn How to Calculate Your Earnings Multiples
Gain a fundamental understanding of earnings and revenue multiples. Explore how comparable data helps establish benchmark multiples, then learn to calculate your business's multiple by evaluating key risk factors and financial performance. Excerpted from BizBuySell's Guide to Selling Your Business.
Transcript
Two of the most common ratios used are revenue multiples, often referred to as sales multiples and earnings multiples. Revenue multiples are based on the gross revenue shown on the annual business income statement. They involve a fixed figure and therefore some experts feel applying a multiple to annual gross revenue is the most reliable approach
However, because annual revenues cannot reflect how much money the business actually earns, most experts caution that basing the price multiple on revenues does not reflect the health of the business. Revenues do not reflect whether the business is mismanaged or if it has higher than average expenses.
Earnings multiples are based on how much the business earns annually for the benefit of its owner. Owner earnings differ from the annual profit shown on the business year-end income statement or its federal tax return. When pricing small businesses, profit and earnings are defined as follows.
Profit, the bottom line on the business income statement, reflects all business revenue less all legally deductible business expenses to arrive at the lowest possible taxable income.
Annual owner earnings, also called owner's cash flow or sellers discretionary earnings (SDE ), also include all business revenue, but from there deductions reflected on the income statement are revised to arrive at a total showing how much the business actually generates for the benefit of its owner in a normal year.
Preparing a statement of seller’s discretionary earnings SDE. To calculate SDE, a key figure in small business sales, the year-end income statement is recast with the following adjustments.
- Add back expenses that were deducted for interest to appreciation taxes and amortization resulting in what accountants call business EBIDTA earnings before interest depreciation taxes and amortization.
- Add back expenses that benefited the owner directly, such as owner salary and benefits, insurance and auto use.
- Add back discretionary expenses and contributions or donations that another owner might choose not to incur.
- Add back non-recurring expenses to normalize earnings by excluding unusual and one-time transactions of the business.
- If SDE has differed greatly over recent years, work with your accountant to create and present what is called a weighted average.
- To prepare an estimate of your SDE, use the SDE calculation worksheet in the digital toolkit working from your financial statements to fill in the shaded cells. The form automatically calculates entries to reflect your annual owner's benefit, your seller's discretionary earnings or SDE, which forms the basis of the income-based valuation used in pricing nearly all small and medium-sized businesses.
Calculating the earnings multiple. The earnings multiple used in most small business valuations is a number between 1 and 5. Businesses with weakest potential and highest risk have the lowest multiples and businesses with strongest potential and lowest risk have the highest multiples.
To determine the multiple for your business, begin by studying comparable data benchmarks described in the previous section. They provide the most basic ballpark estimates of earnings multiples for businesses matching your size, geographic location or business sector.
You can begin to estimate the earnings multiple for your business by assessing factors likely to signal attractiveness or risk to buyers. To begin, open the earnings multiple assessment worksheet in the digital toolkit.
Consider the questions that accompany each factor and assign a number from 1 to 5 that you feel accurately reflects the condition of your business with one indicating the weakest condition and five the strongest condition. The form automatically averages ratings to provide an early sense of the earnings multiple that your business in its current condition, and, based on your assessment, might command.