Learn the Market Approach to Business Valuation
Discover how to value your business using the market approach, also known as multiple of earnings valuation—the most commonly used method for small business valuation. Learn to analyze comparable data from recently sold businesses of similar size to determine benchmark multiples. Then, calculate seller's discretionary earnings (SDE), estimate your multiple, and apply the valuation formula to determine your business's worth. Excerpted from BizBuySell's Guide to Selling Your Business.
Transcript:
The market approach to valuation.The market approach estimates the value of your business based on data from similarly sized and recently sold businesses in your geographic area or business sector.
It involves multiplying the earnings of your business by the valuation multiple at which similar businesses have sold or are selling accessing comparable data often referred to as comps.
Comparable data is usually sourced through online databases tracking recent listed and recently sold businesses. These databases are typically accessed through business brokers or professional appraisers. You can also access comparable data by visiting BizBuySell.com.
Comp criteria can be targeted by industry, geographic location, financial performance, sale price, and other filters using comparable data to establish valuation benchmarks. Knowledge of the price to revenues or price to earnings ratios, at which businesses similar to yours have recently closed, provides a benchmark for the valuation multipliers you might use to arrive at a ballpark estimate of your business value.
The goal is to compare businesses like yours in terms of industry classification, geographical location, size, in terms of revenue assets, employee earnings, and other financial metrics.
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 ref 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 cash flow or sellers discretionary earnings (SDE), also include all business revenue, but from there, their 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 sell'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.
One, add back expenses that were deducted for interest depreciation taxes and amortization resulting in what accountants call business EBITA, earnings before interest, depreciation, taxes and amortization.
Two, add back expenses that benefited the owner directly, such as owner's salary and benefits, insurance and auto use.
Three, add back discretionary expenses and contributions or donations that another owner might choose not to incur.
Four, add back non-recurring expenses to normalize earnings by excluding unusual and one-time transactions of the business.
Five, if SDE has differed greatly over recent years, work with your accountant to create and present what is called a weighted average.
Six, 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 sell'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 earning multiple used in most small business valuations is a number between 1 and five. 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 five 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.
Doing the math. This is the easy part of estimating value using the market approach.
You have analyzed comparable sales data and learned the multiples achieved by recent sales of businesses similar to yours, based on market comps and your own assessment of the condition of your business.
You have estimated the multiple to use when roughly estimating your business value.
You have recast your year-end income statement to arrive at your sell's discretionary earnings SDE.
You are now a simple calculation away from creating a ballpark estimate of the value of your business.
SDE times earnings multiple equals estimated business value. That single calculation results in the estimated value of your business.