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Selling a Business: Valuation Methods

The myriad methods of valuing a company can seem daunting when it comes to selling a business. The following is a brief examination of the most common types of business appraisals that exist and which might be the best option for your own company.

 

  • Discounted Cash Flow

 

  1. a) Commonly used by buyers to determine how much they should pay for a business, Discounted Cash Flow (DCF) is a calculation of the value of the future cash flow of a business. A range of data points are factored into the calculation, each of which requires detailed investigation and analysis:

  2. i) Estimations of cash flow for each year spanning a period of 5-10 years into the future.
    ii) Discount rate used to value future cash flows against the current cash flow. Included in the rate are several components, including a risk-free rate plus add-ons which takes into account the potential risk of the business acquisition. A shift of a few percentage points in the discount rate can significantly impact the total calculated value of a business.
    iii) Future sale value – the value of the business at a given point in time in the future.

  3. b) When based on DCF, valuations of small- and medium-sized business should be examined in depth by the business owner. It is also advisable to judge the various assumptions featuring in the calculation against sales of comparable business’ as well as using the method in conjunction with the Multiple of EBDITA method detailed below.

 

  • Multiple of EBITDA

 

  1. a) EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortization. Multiple of EBITDA is the most common method of valuation for businesses with at least $500,000 of EBITDA. Using transaction data representing averages for the industry as a whole, a multiple (x4, for example) is applied to the EBDITA to generate a price which reflects the business; real value. While the Multiple of EBITDA method has been criticized since it does not take into account taxes and capital expenditures, it is nonetheless an important method which informs a starting point for buyers, sellers and consultants. Buyers will have different investment and tax requirements, so the Multiple of EBDITA method is a useful tool to help business owners to determine how high they can reasonably set their asking price.
  2. b) Multiple of EBITDA should be viewed more as a basis for informing a seller of the possible range of buyer offers than for providing a definitive valuation. As demonstrated by the chart of transaction multiples for the construction industry, multiples can fluctuate across the sectors of a particular industry, and even within each sector. Experienced business consultants can help fine-tune this method so that it gives a seller the most accurate predictions of market value.

 

  • Multiple of SDE

 

SDE stands for Sellers Discretionary Earnings. Similar to the Multiple of EBITDA method, SDE measures the owner’s normal salary and benefits. This method is most commonly employed in the sale of small businesses which are managed by the owner and where the buyer plans on continuing to run the operation themselves. While the multiples of SDE tend to be lower than multiples of EBITDA, the end value is often the same for both methods in the cases of a large proportion of businesses.

 

  • Multiples of Revenue

 

Multiples of revenue are used in some unique circumstances (as part of the overall valuation weighting) but buyers and lenders generally tend to prioritize cash flow over revenue when valuing a business. For instance, a company that’s looking for a business appraisal in New York which counts $5 million in sales and $1 million of gross profit is likely to receive a significantly lower valuation than a company with $5 million in sales and $1.5 million of gross profit. However, in certain cases, a multiple of revenue calculation will value both companies equally. As a result, this method has some margin of error and is not often trusted by those looking to sell their businesses.

 

  • Book Value of Assets

 

Frequently only applicable in certain cases where the total value of assets exceeds total income figures. This may be appropriate, for example, with companies that have either a surplus of assets relative to the revenue generation or are close to becoming insolvent. This method is seldom used to value a business for sale purposes. Even struggling businesses sometimes have a good reputation or other intangible assets which must be taken into consideration in any estimation of value. Assets considered will include equipment, fittings and fixtures, inventories, client accounts, open orders, customer databases, patents and other intellectual property rights.

Every business valuation will include financial calculations. However, various other factors will also have a large effect, competition among buyers, predictions of market direction, and staff. It is wise to seek the advice of an experienced business consultant to identify the valuation method that is most likely to help you achieve the price which finds a balance between maximizing profit and avoiding a protracted selling period.

Whether you’re looking to have a business valuation in New York, a consultation about your business exit plans in Pennsylvania, or any of the professional services we offer across east coast of the US, we’re here at A. Neumann & Associates to aide in all of your M&A questions/concerns.

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