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Valuation Methods

Valuation Methods

 

Thousands of books and courses have been developed to explain and teach how to value a business. This website will not attempt to cover everything. The below descriptions are very brief. For each of the methods there are many thousands of pages of text explaining the concepts and methods that are used in determining the value of a business using this method.

 

Market methods compare the value of this business with similar businesses that have been sold in the same business area. One key problem with small business sales is that most of the sales are confidential with no disclosure to the public of the sales price, financial records used to determine the sales price, the financial resources of the buyer and many other considerations. For public companies, this information is available and is very reliable. Often in small businesses the market method is a “rule of thumb” method which is discussed later.

 

Income or capitalized earnings or discounted future cash flows EBITDA (Earnings Before Interest Taxes Depreciation and Amortization) This method is generally used for larger business mainly those over $50,000,000 a year in revenue. The formulas that drive this method are very complex have many different components and require a high level of training. Even with Jim Eaton’s 35 years as a CPA and having completed many courses on business valuation this can be difficult. A simplistic thought concerning this is to realize the business has to pay for itself through earnings in the future. If you think of the amortization schedule on a loan, this is part of the concept. Because these earnings are in the future there are interest rates and risk factors that must be considered in determining the value of the business. The standard concept of EBITA was developed in the 1950’s and 1960’s. For methods based on earnings it still is the basic starting point. However, today a term called Sustainable Free Cash Flow which modifies the concept has gained significant importance. Although the concept is here, it is somewhat subjective and accordingly is not totally endorsed by all as a better base number to use in valuing a business. The concept of Sustainable Fee Cash Flow means that for a business to pay for itself over future periods an amount must be subtracted from earnings for equipment replacements and other depreciation equivalents. An example of this would be a car rental company that never made any profits. Without the sustainable free cash flow concept, where new rental cars purchased are considered an expense or at least economic depreciation of the vehicle fleet it would appear to be an extremely profitable business. Because the amount of sustainable free cash flow can be subject to interpretation, EBITDA is often used. The EBITDA method without modification can result in a value that will not be achieved. For businesses under $2,000,000 in revenue, we have not seen this method used in an actual purchase or sale transaction.

 

Liquidation value comes into use when either a company is in a loss position or has been unable to maintain profitable operations for a period of time. The liquidation value is what could be obtained over a reasonable period of time from selling the assets in an organized fashion. This is not a one day auction of everything. It is an orderly liquidation. Depending on the type of assets it may take years to complete a total liquidation. A forced sale will result in a much lower value.

 

Adjusted Book Value starts with the net book value also known as owner’s equity, shareholders’ equity, or partners’ capital or equity. As a beginning point, the financial statements should be in accordance with Generally Accepted Accounting Principles (GAAP). Then the values of various assets and liabilities are adjusted to fair market value for each of the items. An example would be, if there was a building that had been substantially depreciated and in the market place it had appreciated in value. This would be increased to the current fair market value. Similarly, physical property, patents and other assets would be evaluated to determine the fair market value for each of the assets. There may be other adjustments needed for off balance sheet leases that in essence are above or below market value.

 

Public Company Guideline Methods use stock market information to compare publicly traded companies based on total capitalization, earnings per share and much more information. Because small and mid-sized businesses are not publicly traded the information is not available and does not really compare to these larger companies.

 

Analysis of Prior Sales of Stock Although small businesses do not normally have many sales of stock of the company, it does occur. Additionally, buy-sell agreements are more common with small businesses today. The formulas and methods in these agreements may be a starting point for the value of the business. If the agreements have values that are binding and have been recently updated there is a strong indication of the value of this business. In litigation the formulas in the buy sell agreements are often looked at by the courts as a method of valuing the business.

 

Rules of Thumb– The textbooks and most valuation specialists will advise you that they are not valid and should not be used. I agree most of the time. However, they may be useful as a figure for a reality check. Many small businesses, that is those under $500,000.00 in revenue will often sell based on these rules of thumb. For instance, small CPA firms will sell for .75 to 1.50 times annual revenue. Small insurance agencies will often sell for 1 to 2 times annual renewable commissions. Generally speaking the businesses with the lower profits will be in the low ration and the businesses with the highest profits will be in the highest range. These are just a few examples there are many more. We have a chart of some of the rules of thumb that I have compiled from various sources and actual transactions. Contact us and we will send you this chart. It does not include every rule of thumb that are in use, but it does contain over 100 examples.

 

Owners Discretionary Cash Flow Multipliers This method involves determining the sustainable free cash flow of a business without including any compensation or costs associated with the owner. In small businesses, those mostly with under $5,000,000 a year in revenue there are expenses that would not have been incurred by a non-owner. Some of these types of expenses involve family members on payroll that may not be compensated equally with non-family members. Certain travel, entertainment and automobile costs may not have been incurred by non-owners. Also, retirement plan contributions in small business are often skewed to compensate the owners as much as is allowed by the IRS. Although some owners go to extremes to the point that deducting these costs is a violation of the Internal Revenue Service Laws, most are just aggressive. After the discretionary cash flow is determined a multiplier is then used times this number to determine the value. The multiplier may be higher or lower depending upon the length of time the business has been in existence or the stability of the earnings. A low multiplier number is 1.25 a high multiplier number is 5. In some respects, these numbers indicate how long it will take for a buyer to recover their purchase price – if – they work for free over this period of time and do not incur any discretionary expenses.