Rules of Thumb
If you’d like a few simple rules of thumb, do NOT start with a percentage or multiple of revenue. Revenue, while necessary, does not ultimately pay the bills. Other rules of thumb might be industry-specific, such as a multiple of renewal revenue in an insurance agency. This is a dangerous way to value a business. These rules of thumb might tell you what cash flow ‘should’ be, but what if the seller is selling products or services at cost or slightly above cost? This increases revenue, but not cash flow. Want to do it right? Start with what the business earns in a given year. Most business brokers would define this as Seller’s Discretionary Earnings or SDE, for short. You can think of SDE as EBITDA (Earnings Before Interest, Taxes, Depreciation, & Amortization) + Owner’s Salary (salary, NOT distributions) + one-time adjustments. Most small businesses trade for 1 – 4 times their annual Seller’s Discretionary Earnings (SDE). Why 1 versus 4? What adjustments are included in SDE? Is SDE the same as net profit (answer = no)? These are the million dollar questions. Most online guides are wrong. You must know what adjustments are acceptable to buyers and the banks. This is also where most business brokers go off the tracks. Here at CGK, we know what is acceptable and what is not.
Most medium-sized businesses trade off of a multiple of adjusted EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). Depending on the size of the business, the trends, and the industry, this is normally 2 – 5 times for lower-middle market businesses and 3 – 8 times for solid, middle-market companies. When do we use adjusted EBITDA versus SDE? What’s the difference between the two? What adjustments are acceptable for these businesses? What about multiple expansion or contraction during the business cycle? You may say, “These numbers are backwards-looking, what about my future numbers?” “What’s this ‘intrinsic value’ that Warren Buffet talks about?” Do you see the problem with ‘rules of thumb’? For a relatively inexpensive business valuation, especially compared to the money at risk, CGK Business Sales can guide you down the right path, so you can make an informed decision. Can you really afford to make a mistake?
Multiple Approaches to Business Valuations
There are a number of different business valuation methods that are in use today, but three that any business owner will want to know about are the asset approach, the income approach, and the comparable transactions approach.
Asset Approach to Business Valuation
This business valuation approach is done by determining the values of the assets and liabilities for the business. The liabilities are subtracted from the assets, and the difference is going to be the value of the business. This can be a great way to determine the value of the business if the business may not continue and needs to be liquidated, as it’s relatively simple to determine the value of all assets and liabilities. However, this doesn’t take into account things that are valuable to the business but that don’t have a price that is easily determined, such as intangible assets. In general, the asset approach is usually not used for businesses that will remain as a going-concern, though it can be a baseline figure.
Income Approach to Business Valuation
This method takes into account what the business will make in the future and discounts this amount back to a present value. Examples of this approach include discounted cash flow and capitalization of earnings methods. For instance, in the discounted cash flow (DCF) methodology, the future amount the business should likely earn is determined. Then, a discount rate is applied to determine the terminal value and present sum of the business’s future cash flows. This determines the current value of the business. Sound confusing? It is. A properly trained M&A advisor can walk a seller through this important way of valuing a business. This lets potential buyers see how well the business could do in the future, plus allows for businesses with uneven cash flows to be properly valued. The income approach is the theoretically correct way of valuing the business, so it cannot be ignored. Though, predicting future cash flows is, of course, hard, especially when it comes to the cyclical nature of most businesses and economic cycles.
Comparable Transactions Approach to Business Valuation
This is a common way to determine the value of a business. The business model is compared with similar ones that have been sold recently to determine the value of the business. This method takes into account the current market for buying and selling businesses, and is a common methodology for business valuations. This method can suffer from peaks and valleys in different economic cycles. It can still be an effective way to market a business and is one that has often been used very often in the past to determine the value of a business before it is sold. As part of the comparable transactions approach, many buyers and sellers may speak of market multiples, often valuing the business as a multiple of adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization) for larger businesses or SDE (seller’s discretionary earnings) for smaller, main street transactions. There are often adjustments made for buying the entire business, called control premiums, or discounts, for lack of marketability or size. Which multiple is used and the adjustments made, either via add-backs or discounts/premiums, can make or break the value for a seller.
Which valuation approach is right for you?
Business owners will want to make sure they take the time to learn more about the various approaches that can be used and work with a professional to ensure they find the right one to help them determine the valuation for their business to help them with a sale. A mergers and acquisitions advisor is going to be able to work with the business owner to determine which or all of these approaches is going to be the right ones to use for their business to prepare for a sale.
So which valuation methods are the right ones for your business and what are the differences between them? Speak with an expert business broker today to learn more about selling your business and about how to choose the right business valuation. This is an important step you’ll want to do carefully when you’re ready to sell your business. Call or confidentially email CGK Business Sales below to determine the value of your business.
What They’re Saying
Excellent service. I was in need of a valuation for a possible acquisition. Greg was extremely thorough. All my questions were answered in a timely manor. I couldn't be happier with the results. Thank you for all you do.Darin LaFonCGK Business Sales Provided a Valuation for This Buyer, Darin
Had an expert evaluation of my company. Greg was smart and up front with answering all my questions and concerns. Great service.Nicolas RainesCGK Business Sales Provided a Business Valuation For Nicolas's Company
Greg did a excellent job . He explained us every detail about the valuation. We had no idea at the beginning, however, we learned a lot with his guidance. He answered all the questions and concerns. CGK Business Sales is one of the best valuation companies in DMV. They have great customer service .Tuncer TurkerCGK Business Sales Provided a Business Valuation for Tuncer's Partner Buyout
I contacted CGK Business Sales to complete a valuation for my late father's business. They were extremely knowledgeable and turned around an accurate valuation in record time. They took the time to walk me through all items they completed so I fully understood how they landed on the final numbers. Also, I can't say enough about Greg. He played a huge part in me selling my father's company. He gave me invaluable contacts that were honest, forthright and experts in their fields. I would highly recommend CGK Business Sales, Greg and his team to family members, friends and people I do not know. If you need help do it right the first time and contact the right people. These guys are the right people.Kristin ChaumontCGK Business Sales Provided a Business Valuation for Kristin's Family Business
Greg Knox, MBA, CFA has spent his 20+ year career in investment banking, private equity, a multi-billion dollar hedge fund, and institutional trading, at such institutions as Deutsche Bank, T. Rowe Price, and Wachovia... (click Greg's picture to read more)
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