How Much Is My Business Worth? Part 2 - Valuation Multiples

 

Edward L. Fixen, President

BusinessQuest

 

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.  Part 1 of this two-part article discussed valuation methods and discretionary earnings.  Part 2 discusses valuation multiples, which are used together with discretionary earnings to estimate the fair market value of existing, small and medium sized businesses. 

 

 

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 (MDE) 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 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.

 

Discretionary earnings are simply the pre-tax, income 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 earnings of a private, closely-held business requires an in-depth understanding of all sources of income, expenses and operation of the business underlying the financial statements and tax returns.  “Discretionary earnings”, once accurately determined, form one of the two factors used to determine fair market value.  The next step is to determine a “Multiple of Discretionary Earnings”, or valuation multiple, which is combined with the “Discretionary Earnings” to determine a fair market price for the business.

 

 

The most subjective part of any valuation is determining the valuation multiple or “Multiple of Discretionary Earnings.”  Estimating a valuation multiple is highly subjective for two reasons.  First, there is no universal, purely objective method for determining a valuation multiple.  Second, a valuation multiple is really a relative measure or ranking of a particular business relative to a “market average” business and should consider all the factors that determine the relative worth of a business.  As such, a valuation multiple is really a matter of professional opinion.  Understanding the subjective nature of a valuation multiple helps explain the all too common disparity in the opinion of value between a seller and buyer.

 

It is also important to keep in mind that in the context of this article, as the name “Multiple of Discretionary Earnings” implies, valuation multiple as used in this article is a multiple of “Discretionary Earnings” and not a multiple of EBITDA.  Valuations using a multiple of EBITDA are quite common for large companies (i.e., annual sales greater than $20 million) but are not appropriate for most small and medium sized privately held businesses.

 

In general, valuation multiples of “Discretionary Earnings” for most small and medium sized businesses fall within a range of 1 to 3.  Of course some businesses are sold for valuation multiples lower than 1 or above 3, but statistically the vast majority of sold businesses fall within the range of 1 to 3.  An article in the October edition of “The Business Broker” Newsletter, published by the Business Brokerage Press, indicated that the median “Multiple of Discretionary Earnings” for 3,823 small and medium sized business transactions was 2.5.  This means that 50% of the businesses analyzed sold for less than 2.5 times “Discretionary Earnings” while 50% sold for more than 2.5 times “Discretionary Earnings.”

 

The actual valuation multiple for a specific business depends on many factors such as size of the business (e.g., annual sales volume), industry, years in business, sales and profit growth, profit margin, experience of management team, etc.  For example, the “Business Broker” Newsletter article cited above, noted a trend of increasing valuation multiples corresponding to an increase in annual sales.  The following table is an excerpt from the Business Broker Newsletter article that shows a relationship between valuation multiples and sales volumes.

 

Number of Transactions	Annual Sales ($)	Discretionary Earnings Multiple
		Lower Quartile*	Median	Upper Quartile**
1833	0-500,000	1.36	2.08	3.28
746	500,000 - 1,000,000	1.55	2.41	3.56
492	1,000,000 - 2,000,000	1.78	2.72	3.93
295	2,000,000 - 5,000,000	1.68	2.97	4.87
115	5,000,000 - 10,000,000	2.69	4.44	6.27
316	10,000,000+	3.71	5.79	7.83
3823	All Transactions	1.55	2.5	4.06

              * -  25% of all transactions were below the Lower Quartile Value

            ** - 25% of all transactions were above the Upper Quartile Value

 

The table above highlights a very important point.  The less risky a business, the higher the valuation multiple and therefore the higher the fair market value of the business.  A business with sales of $10 million is significantly less risky (i.e., less likely to fail in the future) compared to a business with sales of $1 million.  Therefore, the business with higher sales volume is able to command a higher price premium or higher valuation multiple.

 

From a buyer’s perspective, valuation multiples in their simplest form can be thought of as a payback period.  For example, a valuation multiple of 3 means it will take 3 years before the annual earnings of the business pays back the purchase price.  Alternatively, some investors consider the valuation multiple to represent the investment capitalization rate (i.e., Cap Rate) or return-on-investment rate.  When inverted, a valuation multiple represents the cap rate or the annual return-on-investment before any assumptions for future growth.   For example, a valuation multiple of 3 can also be thought of as representing a cap rate or return-on-investment rate of 33% (i.e., 1/3).  

 

It should come as no surprise that cap rates for small, privately held businesses are significantly higher compared to other conventional investments such as stocks, bonds, etc.  The risk associated with a small business investment is relatively high compared with other investments and therefore it is reasonable to require a much higher return-on-investment rate for a small business.  This explains why the valuation multiples for small businesses generally range from 1 on the low side to 4 on the high side because higher multiples would imply that small business investments are relatively comparable to large business, stock or mutual fund investments, which is not the case.

 

Hopefully this article sheds some light on the business valuation process while underscoring the complexity and need for an experienced professional when valuing your business.

 

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