How Much Is My Business Worth? Part 1 - Valuation Methods & Discretionary Earnings

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How Much Is My Business Worth?

 

Part 1 - Valuation Methods & Discretionary Earnings

 

Edward L. Fixen, President

BusinessQuest

 

That’s the One Million Dollar question.  Or is it the Two Million Dollar question?  Clearly, understanding the value of your business is probably the first and most critical issue a business owner will need to address when considering the sale of a business.  It is not uncommon for business owners to feel that the value of their business is higher than may be economically justifiable.  This article will provide insights into the business valuation process for small to medium sized businesses and help gain a better understanding of the factors that determine how much a business is worth.

 

Valuation Methods

 

There are numerous valuation methods for determining the value of a business.  In the case of large businesses and corporate America, the most widely accepted valuation method is the Discounted Cash Flow Method.  In the case of small and medium sized businesses, the mostly widely accepted business valuation method within the business brokerage industry is the Multiple of Discretionary Earnings Method.  There are numerous other methods that can and may need to be considered depending on the particulars of the business under consideration but for a small or medium sized business the Multiple of Discretionary Earnings (MDE) Method should be one of the methods if not the primary method used to estimate fair market value for a small or mid sized business.

 

There are two fundamental factors in the MDE Method that are used to determine the estimated fair market value of a business.  As the name implies, these two factors are the discretionary earnings of the business and a multiple applied to the discretionary earnings to arrive at a capitalized value of the business.  For example, if the discretionary earnings of a business were $500,000 and the valuation multiple was estimated to be 3; the estimated fair market value for that business would be 3 times $500,000 or $1.5 million.  Obviously, this seems quite simple once the discretionary earnings and valuation multiple are determined.  However, determining the actual discretionary earnings of a business is not as simple as it might seem and the process of estimating a valuation multiple is subjective and requires valuation experience along with an understanding of the market.  The next two sections will address each of these two fundamentals, discretionary earnings and valuation multiples, in greater detail.

 

However, a couple points regarding what’s included in the value estimated by the MDE Method need to be highlighted before moving onto discretionary earnings and valuation multiples.  It is important to understand that the value estimated by the MDE Method does not include the value of inventory, cash, accounts receivables and other liquid assets.  Since inventory is typically included in the sale of a business but not included in the value calculated by the MDE Method, it may be appropriate to add the value for the inventory to arrive at a fair market value or negotiate the purchase of inventory separate from the purchase price. 

 

It is also important to understand that the structure of the deal (i.e., asset sale verse stock sale) will also affect the final asking price.  In an asset purchase, which is by far the most common type of deal structure in small and medium sized business acquisitions, items such as bank accounts, cash, accounts receivables and any liabilities of the business are typically excluded from the purchase and price.  For businesses with a strong balance sheet (i.e., value of current assets exceeds the value of liabilities), this means additional proceeds to the seller in addition to the sale price.  In the unlikely event of a stock sale, the value of the bank accounts, cash, accounts receivables, inventory and all liabilities would be added to the value estimated by the MDE Method to arrive at a fair market value.  The topic of asset sale verse stock sale is another critical issue that must be addressed with input from your business broker, accountant and attorney when considering the sale of a business but is not addressed further in this article.

 

Discretionary Earnings

 

As the saying goes, “Cash is King.”  This is true when running a business and when selling a business.  Discretionary earnings are simply the pre-tax, real cash generated by a business.  One definition of discretionary earnings is “Earnings Before Interest, Taxes, Depreciation & Amortization” (EBITDA) plus owner’s compensation/benefits and one-time extraordinary expenses.  Whichever definition you use, determining the real cash flow of a business requires an in-depth understanding of the true income, expenses and operation of the business underlying the financial statements and tax returns. 

 

However because most business owners are very adverse to paying any more income tax than absolutely necessary, the tax returns for most businesses show a net income that minimizes income tax on the business.  Obviously, this makes it very difficult to truly understand the real earnings of the business without an in-depth analysis.  That is why understanding the underlying business and recasting the financials to capture the real earnings of the business is so critical.

 

Recasting of the business financials usually involves many adjustments to the reported net income of a business to arrive at the actual discretionary earnings.  After adjusting for or “adding-back” interest, taxes, depreciation, amortization and any one-time, non-recurring expenses to net income, it is necessary to identify and “add-back” owner related compensation and expenses.  Examples of owner compensation and benefits include salary, personal auto expenses, health or life insurance and similar personal benefits that are discretionary in nature and not inherent to operating the business.  In some cases there may family members on the payroll whose salary is above industry norms or even unnecessary and the excess salary should be added to the discretionary earnings.  In other words, discretionary earnings represent the total earnings of the business that a new owner would have at his/her discretion to allocate to retained earnings, salary and any other personal compensation or benefits. 

 

In some cases, there may need to be adjustments that reduce the discretionary earnings.  The most common example involves fair market rent adjustments.  For example, when a business owner also owns the property where the business is located but has not been expensing rent or has been charging below market-rate rent, it is necessary to reduce the discretionary earnings by an amount corresponding to the difference between the market-rate rent and the actual rent.

 

“Discretionary earnings”, once accurately determined, form one of the two factors used to determine fair market value.  The next step is to determine a “Valuation Multiple” which is combined with the “Discretionary Earnings” to determine a fair market price for the business.

 

Check Back Next Month For Part 2 Of This Article Regarding Valuation Multiples