Category: Business Valuation
How to Value a Small Business Using Earnings Multiples
A business owner or prospective seller may want to know the value of their business before deciding to put it on the market. Buyers may wish to calculate the value or compare the asking price of a business they are interested in. In the case of business owners considering the sale of their business most business brokers offer a free Market Value Analysis and in fact our firm offers a comprehensive Business Market Value Analysis to prospective sellers. In either case, the simplest method to obtain an approximate business value is to use the Earnings Multiple method (also known as Market Data, Comps, Discretionary Earnings or DE Multiple).
Most business buyers and sellers/owners are somewhat aware of earnings multiples but few understand how to properly use and apply these multiples to value a business. There are many myths and opinions about what a business is worth and what “the” earnings multiple is. In fact earnings multiples vary widely by industry as well as by earnings. There are different multiples for Discretionary Earnings (DE aka SDE or Seller’s Discretionary Earnings) and EBITDA (Earnings Before Interest Taxes Depreciation & Amortization). DE multiples are lower than EBITDA multiples because with DE you are multiplying a higher earnings number against a lower multiple and with EBITDA you are multiplying a lower earnings number against a higher multiple. Ideally you should get roughly the same value for both approaches. There are no valuation multiples for “net profit” for a small-midsize business and simply applying say a DE multiple to Net Profit will result in a dramatically undervalued figure for the business. As explained below, the Net Profit does not reflect the actual earnings of a small business, thus using it for valuation purposes is meaningless.
While Earning Multiples seem like a simple method to value a business, and they can be, they must be used correctly and on the right earnings value to deliver the correct valuation for a business.
Discretionary Earnings vs Net Profit vs EBITDA
First you need to understand the difference between each earnings type and how to calculate them, then look at how to apply them.
- Net Profit:
This is the starting point for calculating both DE and EBITDA. When a business broker or valuation analyst refers to Net Profit this is the Net Profit shown on the company tax returns. The Net Profit on the company P&L is often different from the Tax Return Net Profit as a result of changes made by the accountant or CPA at year end which were not reconciled with the P&L. The Tax Return Net Profit is the only figure used for valuation purposes (note that SBA lenders and valuation analysts only use the Tax Return Net Profit).
EBITDA is actually simple to calculate. Start with the Net Profit from the Tax Return and add the Interest, Taxes, Depreciation, & Amortization. This is the non-normalized EBITDA and for very large businesses this figure is correct. For small businesses we must subtract a replacement salary for the owner at market rate. This would be the salary of a manager to run the business in
place of the seller. This is called Normalized EBITDA which is used for small businesses.
- Discretionary Earnings (DE):
DE is the most commonly used valuation multiple and it is also the most complicated figure to calculate. DE basically is EBITDA + owners salary + owner’s benefits & expenses. This sounds simple enough and it would be except that many owners bury these expenses which can make it difficult to verify these figures. One key rule for owner’s expense add backs is that they MUST be tied to an expense line item on the tax return. If the expense is not shown on the tax return then it cannot be used as an add back for calculating DE as it was not shown as an expense on the tax return, which is what is used to calculate DE.
Finding the Right Earnings Multiple for a Business
You can get Discretionary Earnings multiples and Business Valuation Reports from BizBuySell and Peercomps. BizBuySell offers valuation reports from $19.95 to $59.95 and Peercomps offers a one time comps search for $49 or a one time business valuation for $99.
The BizBuySell valuation is the simplest to use and the least expensive. While it is good for determining a price range, the downside is that it is not an accurate valuation program. You should only use it for validating a price range and not for determining an exact business value. Note that the comparable sales data in BizBuySell is broker provided, meaning that brokers input this data when a business is sold through BizBuySell. There are thousands of transactions in the database, the problem is that the way brokers record transactions can vary, making the data less consistent than Peercomps.
The Peercomps valuation is more comprehensive and uses better comparable sales data as their database is from actual closed SBA financed transactions. All SBA loans require an independent (third party) business valuation (appraisal) by a CVA (Certified Business Valuation Analyst). Thus this comparable sales data is more accurate and more consistent than broker provided comps. The downside of Peercomps is that it is much more complicated to use and obtain an accurate valuation. The user should be familiar with valuation methods in order to use Peercomps.
Steps to Finding Earnings Multiple Comparable Sales Data
- In BizBuySell or Peercomps select the Industry-Business Type (e.g. Distribution, Restaurant, Manufacturing, Construction – note that you can select more specific business types)
- Narrow the Gross Sales and Income ranges to values below and above the company’s annual revenue and income. Set a minimum value to eliminate businesses much smaller than the company you are considering and a maximum to eliminate businesses that are much larger.
- You can change the ranges to narrow or expand your results until you have a suitable number of comps (preferably at least 5 to 10 or more. In some cases there may be very few if it is a small niche).
- Now you should have comparable sales multiples for Discretionary Earnings and if you used Peercomps Normalized EBITDA as well. The next step is to apply the multiples
- Most DE multiples do not include inventory or A/R (Accounts Receivable) and also assume that all liabilities are paid off by the Seller at closing.
- Peercomps multiples include “normal” inventory and BizBuySell comps may or may not.
- Normal inventory is the inventory required to operate the business. Excess inventory is not included in the earnings multiple.
Applying the Earnings Multiple to Determine Business Value
If you are using the valuation report from BizBuySell or Peercomps you can input the company earnings and revenue to obtain a value based on the Mean or Average Discretionary Earnings multiple. If you elected to obtain comparable sales data only your next step is to multiply the Mean or Average DE multiple to the DE you calculated. This will give you a value based on the Mean or Average multiple.
It is important to note and understand that the figure you just calculated is not an exact figure. The multiple you just used is an average. Thus, half of the businesses in the comps sold for less than that multiple and conversely half sold for more than that figure.
If you are considering a business that is exceptional it may be worth a premium and the average multiple may be on the low side. Likewise, if the business is below average it may be appropriate to apply a discount.
7 Factors that Affect Business Value and Earnings Multiples
- Quality of Financial Data
- Quality of Product or Service
- Years Established
- Quality & Experience of Staff
- Infrastructure, Systems, Procedures
- Customer Concentration
Earnings Multiples are a convenient and relatively simple way to calculate business values, but as we discussed above, it is not an exact value and more of an average value. If you are buying a business the Business Broker should have a Recast Financial Statement showing the financials from the Seller’s tax returns and all of the add backs to arrive at the Discretionary Earnings. The Broker should also be able to provide you with Comps Data and a Market Value Analysis.
If you are Selling your business we recast your financial statements and prepare a comprehensive Market Value Analysis as part of our initial review of the business to determine the asking price.
INFORMATION ON BUYING-SELLING A BUSINESS
How to Determine the Value of a Business
What is the value of my business? This is the first and foremost question on the mind of business buyers and sellers. Business owners that are either considering selling their business or preparing to sell their business need to know what a realistic market value is for their business. Buyers face the same question when they are searching for and considering businesses for sale; what is this business actually worth? Below we explain what a formal Business Valuation is, Market Value Reports, and how to obtain a good estimate of the market value of a business on your own.
Business market values are not as simple as residential real estate where you can go to Zillow or other websites and quickly see what similar homes in the area are selling for. First there are many different types of businesses-industries, and each is valued very differently. Secondly, business values are driven by earnings, so even businesses in the same industry will have very different values depending on their earnings.
Businesses are actually valued by very specific methodologies and there are a number of industry certifications for analysts trained and certified in Business Valuation. The most common professional designations for valuation analysts are CVA (Certified Valuation Analyst), ASA (Accredited Senior Appraiser), CBA (Certified Business Appraiser), and ABV (Accredited in Business Valuation). Many professional Business Brokers have had formal training in business valuation from organizations like CABB (California Association of Business Brokers) or the IBBA (International Business Broker Association) which offer a number of classes in recasting financial statements and business valuation.
A formal third party Business Valuation typically ranges from $2,500 to over $5,000 or even $10,000 depending on the purpose of the valuation. For example valuations for divorces or related to litigation are much more extensive and hence more expensive. Basic third party valuations for smaller businesses can be obtained for around $1,750. Most professional Business Brokers, including our firm, offer free Market Value Reports.
So what’s the difference between a “Market Value Report” and a formal third party valuation? Many Market Value Reports are very basic and do not include an in depth review of the businesses financial statements. At Pacific Business Sales our Market Value Report is comprehensive. We recast the last 3 years financial statements following CABB and IBBA guidelines, use Peercomps business valuation software to obtain relevant comparable sales data, and use the Peercomps valuation software to calculate an accurate Market Value based the Market Data Approach (comps) and the Income Approach (discounted future cash flow model). This results in an accurate data driven business value.
A Simple Method to Determine the Value of a Business on Your Own
The simplest way to value a business is the Comparable Sales Method, also known as “comps”. Comparable Sales databases provide average sales values based on the industry type with average multiples of Discretionary Earnings, revenue, and in some databases EBITDA (Earnings Before Interest Depreciation Taxes & Amortization). Chapter 11 of my book, “Own Your Future” explains how to value to a business with examples of using comps to estimate business values.
The concept for using comps is simple, select a similar industry, then select companies with similar revenue and earnings and use the earnings multiples to determine the value of your company. The obvious question is where do I get comps?
Business Brokers and analysts have access to professional databases that are not available to the public. However, you can access a database of both for sale and sold Comps and run a basic valuation through BizBuySell.com for $19.95 to $59.95. While this is not a formal business valuation, it is a good tool for estimating the market value of a business and it is very simple to use. The BizBuySell.com business valuation tool is easy to use and also easy to obtain erroneous results as the database is not as accurate as others because while the data is from closed transactions it is broker provided figures.
Peercomps offers a more comprehensive valuation tool which is used by business brokers and valuation analysts. The Peercomps database is from actual closed SBA financed transactions and the valuation data is from the actual independent business valuation prepared by a Certified Valuation Analyst. You can obtain a free comps report for your industry and a complete do it yourself valuation report for $99. This is a great deal for a valuation, but it is fairly complicated.
Steps to Calculate the Market Value of a Business
To get an accurate market value you must use the correct value for the company’s Discretionary Earnings and revenue. While revenue figures are easy to obtain, calculating the correct Discretionary Earnings is more complicated (see What is DE for more information). Simply put, Discretionary Earnings are the total economic benefit of owning the business. This includes the owner’s salary, health and life insurance, and other owner’s benefits such as travel & entertainment, auto expenses, and other personal expenses.
To calculate the DE start with the net profit on the tax returns and then add back the owner’s salary and benefits. It is important to ensure that all expenses are shown on the tax return (some may be shown on expense statements on the tax return or buried in general category). Expenses that are not tied to a line item on the tax return should not be added back.
- Tax Returns: You’ll need to have the last 3 years or Federal Tax Returns to calculate the DE for Peercomps. For a rough estimate you can use an estimated DE but remember, a small error on the DE will result in a big error on the estimated market value since this is multiplied by the DE Multiple.
- Calculate the DE (Discretionary Earnings).
- Comps: look up comparable sales for businesses in the same industry with similar revenue and earnings. It is very important that the industry, revenue and earnings are all similar to get reliable comparable sales figures and multiples. When selecting the comparable sales to use, remove any that have much higher or lower earnings than the company you are considering and use comps from businesses that are as close as possible to the company you are evaluating. Preferably you should have at least 5 or more comps.
- Apply DE and EBITDA Multiples: Use the DE and EBITDA multiples from your comps to multiply against the DE and EBITDA for the company you are considering.
For a Free Market Valuation of your business Contact Us.
How Much Money Does a Small Business Make? What are Discretionary Earnings (DE)?
The burning question for buyers looking at prospective small businesses is “how much does this business make?”. This is actually the wrong question. The right question is how much does the owner make? One of the first steps in preparing to sell a business for a professional business broker is determining the Discretionary Earnings of the company.
If you just look at the net profit shown on the business tax returns for most small and midsize businesses it looks like they don’t make much money. What you are missing is the owner’s salary, benefits, and expenses that are run through the business in order to minimize their taxes. These expenses include the owner’s salary, 401K or other type of retirement plan, health and life insurance, auto expenses, travel and entertainment, etc. These expenses can be a significant amount of money, consequently the Discretionary Earnings for a business are always substantially higher than the net profit shown on the business tax returns.
One of the first questions to address is which financial statement to use, the P&L statement or tax returns? The Federal Tax returns are always used for business valuation purposes. The P&Ls are used for expense details and supporting documentation, but the tax returns are treated as the official and final financial statement for the business.
Adding Back Owner Benefits & Expenses (Addbacks)
What is a legitimate owner benefit-expense addback? The simple answer is any expense that is not a necessity for business operations. There is however a caveat to this, in order for an expense to be a legitimate addback it must also be shown on the business tax returns as an expense line item or be part of an expense line item. Expenses not shown on the tax return (e.g. on the P&L or claimed by the owner) would not be added back because these expenses are not being deducted from the business gross margin as an expense. In other words, these expenses didn’t happen from a tax return standpoint.
In addition to owner benefits and expenses there are other addbacks to calculate the DE for a business. These are Depreciation, Amortization, Interest and Taxes. These expense items aren’t “owner benefits” so why would these be added back? While Depreciation and Amortization are not actual owner expenses, they are what is called a “non-cash” expense. There were no checks or actual payments made to Depreciation or Amortization and in fact many small business P&Ls don’t show these expenses. These expenses are added to the tax return by the CPA to write off capital expenses like vehicles, equipment, franchise agreements, and other asset purchases over the life of the asset. For example, a vehicle purchased for $50,000 might be expensed through depreciation over 5 years resulting in a $10,000 per year depreciation expense.
Interest is clearly an actual business expense so why is that added back? While the current owner may have interest expense in the business, it will certainly be very different from the interest expense the buyer will have. So the DE calculation adds back interest to arrive at the business earnings with zero debt and the buyer can subtract their expected debt service (expense) from the DE to arrive at a net after debt service figure for the business.
Banks use this same methodology to calculate the net after debt service earnings of a business for SBA financing.
Common Owner-Seller Addbacks to Calculate DE (Discretionary Earnings)
Below are the common expenses added back to the tax return net profit to arrive at the DE for business.
- Interest Expenses (see explanation above)
- Depreciation (see explanation above)
- Amortization (see explanation above)
- Officer’s Salary (if it is the owner’s salary)
- Family member salary-wages
- Health & Life Insurance (owners)
- Pension & 401K (owners)
- Travel & Entertainment (if not business essential)
- Auto Expenses (owner’s personal vehicles)
- Other Common Expenses where Owners may have Expenses:
- Office Supplies
- COGS (Cost of Goods Sold) – some owners run expenses through this category. While the expenses may be valid, many banks question expenses in this category and you will need receipts that clearly show these are non-business expenses.
- Misccelaneous Expenses
- Legal & Professional
What’s the Difference Between EBITDA and DE?
EBITDA (Earnings Before Interest Taxes Depreciation & Amortization) is a common financial term and more commonly known than DE. EBITDA is most commonly used for businesses with at least $5 million to $10 million in sales and above. While it is a good metric for larger businesses, it does not include add backs for owner’s benefits which can be substantial. Thus, if EBITDA is used for a small business the figure would be significantly understated which is why DE is the preferred earnings figure for small businesses.
EBITDA is used on mid-sized businesses in some cases such as when the business is managed by a full time manager. If you use EBITDA to calculate the value of a small business you add back any owner salaries and benefits. This is referred to as an Adjusted EBITDA by valuation analysts.
Working with a Business Broker
When a buyer is looking at businesses for sale the business broker will have prepared a Confidential Business Review which will include a calculation of the Discretionary Earnings based on the Seller’s tax returns and stated owner’s benefits and expenses. After your offer is accepted you will have the opportunity to verify the DE by reviewing the Seller’s tax returns, expenses, bank statements, invoices, etc during Due Diligence.
Selling Your Business & Business Valuation Seminar Scams
It starts with an invitation to a “free” seminar about Selling Your Business or the Value of Your Business. Of course you think, why not. When you arrive there’s a number of young MBAs in suits and a couple of more senior people that will be presenting. The presentation is polished and professional, it sounds good, and is very convincing. As the pitch goes, they have a huge pool of buyers looking for businesses just like yours.
Then there’s the catch… In order to sell your business they need a business valuation and/or a prospectus-marketing package that costs between $5,000 to $20,000 or more. They confidentiality throw out a valuation figure, much higher than you expected, and the explanation is convincing. It all sounds great, wow, you never thought your business was worth that much!
Let’s break this down. First, the cost of a professional third party valuation is typically between $2,500 and $3,500 for most businesses. If it is a large company, a complex valuation or if it involves legal issues the cost can be substantially higher, but these are the exceptions. If you want a business valuation you should ensure the firm and individual preparing the valuation is a certified business valuation analyst. We work with several firms that specialize in business valuations and their staff are all certified analysts. Also, our firm as with most professional business brokers, offer a free Market Value Report as part of our services. If you want to know the market value of your business this will suffice. Our Business Market Value Report is based on comparable sales (comps) and cash flow based valuation methods and is very comprehensive.
Second, the marketing package. Our firm as with most professional business brokers do not charge an upfront fee or charge for the preparation of the marketing package. There are exceptions for large M&A transactions, but for most midsize businesses there is no upfront fee. Our fee is paid at closing when the business is sold.
Lastly, will they actually sell your business? Our experience from talking with business owners that have attended these seminars is no. One business owner told us he paid $20,000 and never had a buyer inquire. When he asked for his money back he got a list of buyers they claimed had inquired. Yes, he called the “prospective buyers”, none of them were what he considered real, but he never got his money back and that firm never sold his business.
These seminars have been around for decades under many different company names, but the scam is the same. The problem is these companies charge huge fees upfront regardless of whether they sell your business or not. In fact, the track record these firms have for actually selling businesses is very poor. Before you pay thousands of dollars upfront for a very risky proposition, contact us for a free Market Value Report and consultation.