Valuation is the number one question of all sellers when contemplating a sale, and of course, the concern of most buyers when purchasing a business.Unfortunately there is not an easy answer or there can be several answers.Because business valuation is an art not a science.Valuations are subject to the appraisers judgment, skill and quality of methodology. There are several standards of value for businesses (ie different values!). Fair market value – The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of the relevant facts.Intrinsic value – Stock values that investors would consider. Fair value –Legal standards to value. Often used in divorce. Investment value or strategic value – The value to specific buyers. Could exceed fair market value. Fair market value is essentially what a buyer would pay for the business in an open market. This is a simplification of some very intricate valuation practices. There are valuation experts that specialize in providing very complicated reports. Those reports are often used for IRS inquiries, legal proceedings, intricate financing and other reasons. A full valuation of a business could cost ten to thirty thousand dollars. For small business sales, a valuation is usually not needed, and for the most part our simplified valuation methods are sufficient enough to determine your listing and approximate your eventual sale price.
There are three generally accepted approaches to valuing a business. The asset approach 2. The market approach
3. The income approach. Asset Approach – values the assets of your business minus the liabilities. Some of the methods in this approach are book value, excess earnings method, asset accumulation method to name a few. However these values usually mean very little to the market value of most operating businesses. For the most part the asset approach does not properly represent the value of an ongoing business that has positive earnings. Market Approach – Simply defined, it is much like a real estate comparable method. Like businesses in size and industry sell for similar valuations. There is the guideline publicly traded company method or the merger and acquired company method (private sale databases). There are many databases we can research to find multiples of gross sales and earnings to compare to your business. This method can be very reliable in most cases and is a strong indicator of value. Income Approach – Your business is worth the present value of the income stream it will bring to an investor. There are several complicated methods including the discounted future earnings method as well as several capitalization methods. This approach is also a strong indicator of what a business with positive income is worth. These methods rely on future projections and growth rates to decide what the business may be worth. If that is true
then why do most people multiply or capitalize historical earnings to arrive at a value? Because the assumption is the buyer will maintain the current income levels and they are a reasonable indication of future earnings.
Your business is worth a multiple of your past earnings if a buyer can project those earnings will be maintained after the purchase A multiple can be Net income or EBITDA or Owner’s benefit. In small business sales (businesses earning less than 1 million dollars), we use owner’s benefit. Owner’s benefit equals the net income, plus depreciation, interest, and the owner’s salary and fringe benefits. In other words, all the income available to ONE owner if the company was debt free. EBITDA is used by larger businesses and includes normalized salary and benefit package for an executive to operate your business.
Multiples of owner benefit can run from less than one to about three. If your business is larger and your EBITDA is near or above one million, the multiples can run from four to six which can differ and therefore can be selected after the basic research to decide which multiple to be used for your business. The multiple will rise along with the size, quality, and verifiability of owners benefit. Bad books, dim future, negative growth and little profits equal a low multiple. Excellent books, bright future, excellent growth will garner a high multiple. Buyers determine a business eventual sale price. Not valuation experts. That is why no one can tell you exactly what your business is worth. Not your banker, CPA, lawyer, broker, or mother-in-law. The only individual that will tell you what it is worth is the eventual buyer – and that will be a subjective evaluation. The same business will be valued differently by every buyer.
Your business can be worth any of the following: A multiple of earnings compared to like businesses (gross sales or owners benefit times an industry multiple).A capitalization of the net profit (NOT OWNERS BENEFIT…you cannot capitalize owners benefit!) 20% to 50% or a simple multiple of owner benefit. And if your business makes little or no money- Asset value is the only value. (Goodwill + inventory + equipment +etc.) Either sold as a whole or liquidated over time.
Many other things can affect the value of the business. Location, size, competition, growth rates, industry trends, quality of books, ease of transfer, control issues, time you have to sell, terms of the sale, leverage or what business broker you hire.
EBITDA is not a fool-proof method of valuing a business. BITDA (earnings before interest, tax, depreciation, and amortization) is one of the most widely used metrics in finance, particularly when it comes to valuation analysis and securities pricing analysis. By stripping away “non operational” expenses, EBITDA in theory allows for a cleaner
analysis of the intrinsic profitability of a company. Since then, it has become so widespread that public companies have even begun reporting it in their earnings filings.Given its extensive use, it may come as a surprise that EBITDA has several important critics.The strongest argument in favor of using EBITDA is that it provides a clean metric of profitability without the impact of accounting policies, capital structure and taxation regimes. It exclusively focuses on operating expenses, including the cost of services/goods sold, sales and marketing expenses, research and development, and general and administrative expenses. In summary, EBITDA is supposed to reflect the pure operating performance of any company.Stripping out non-operating expenses can be useful for several reasons. For instance, in an M&A process, if the acquiring company would look to refinance the capital structure of the target company and change the capital expenditure plans, then it would want to use EBITDA to get an idea of what the earnings of the target entity would look like once the merger is executed. EBITDA serves as a proxy for pre-tax operational cash flow. It gives a sense of what cash flows might be expected to come out of the business after an M&A transaction.”Another reason for using EBITDA is that when comparing similar companies in different parts of the world, the effects of the different taxation and accounting systems can often muddy the waters. With that in mind, it would seem that EBITDA is an extremely useful metric. But then why the criticism? Most of the arguments against using EBITDA come down to the following fundamental question: does excluding interest, tax, depreciation and amortization really provide a “truer” picture of the operating performance of a company? Let’s look at this in more detail. Depreciation and Amortization:Working backwards, the first line items excluded from EBITDA are depreciation and amortization. Doing so makes sense in many cases. Depreciation and amortization are in fact non-cash expenses. So much so that the depreciation expense included in the income statement could be related to an expenditure incurred years ago.
In fact, there are multiple ways with which to account for depreciation and amortization, and one’s choice of which method to use will have a significant impact on the reported earnings of a company. Depreciation and amortization are unique expenses. First, they are non-cash expenses — they are expenses related assets that have already been purchased, so no cash is changing hands. Second, they are expenses that are subject to judgment or estimates — the charges are based on how long the underlying assets are projected to last, and are adjusted based on experience, projections, or, as some would argue, fraud.” That’s why excluding depreciation and amortization can in theory paint a more realistic picture of true operational performance.However, is this always the case? Some argue not. For companies in capital-intensive sectors like telecoms, for instance, depreciation and amortization are two of the major expenses and can’t be ignored as they're capital expenditure form a major chunk of the cash outflow. Towers and network equipment are real expenses and depreciation and amortization are the annual charges the business is taking through its income statement. Another industry where using EBITDA could be misleading is the shipping industry — again a very capital intensive sector.Let’s look at a real world example:If we just take EBITDA of a telecommunication service provider to analyze the results in 2015-2017, we might conclude that it’s a great business with history of making large profits year after year
|Year ending Mar. 31, $ millions
|Cost of Services and Products
|SG&A and Other Operating Expenses
However, if we go further down the income statement and look at earnings before interest and taxes (EBIT) before taking into account the effect of depreciation and amortization, we arrive at a completely different conclusion. In fact it hardly seems to be making any money in the business, whereas its EBITDA runs into billions of dollars.