Valuing a privately held business can seem daunting when you consider all of the possible methods of a company valuation. Outlined below we briefly discuss the most common types and which are most appropriate when selling a business in the market.
Asset Value
Usually only applies where the asset values exceed values based on income. Examples are companies that are either struggling financially or have an excess of assets relative to the revenue generation of the business. Rarely used in valuing a business for sale. Even struggling businesses sometimes have goodwill or other intangible assets that a buyer may pay extra. Assets considered will include equipment, fixtures, inventory, accounts receivable, open orders, customer lists, patents and other intellectual property.
Discounted Cash Flow
a) Discounted cash flow(DCF) is often used by professional buyers when determining the amount they want to pay for a business. Basically this calculation is the present value of future cash flows of the business. Many factors go into the calculation and each of the factors requires making assumptions and judgements. Most importantly there are three data points to be decided:
i) Cash flow for each year into the future – usually 5 – 10 years.
ii) Discount rate used to value future cash flows in todays value. The rate includes several components including a risk free rate plus add-ons to account for the risk of the particular investment. A few percentage points in either direction with the discount rate can have a large impact on the calculated value.
iii) Future sale value – what will the business sell for at the end of the time horizon.
b) Small and middle market business valuations based on DCF should be carefully scrutinized and because of the various assumptions made in the calculation should be considered in conjunction with comparable transactions and the multiple of ebitda method below.Multiple of EBITDA
a) EBITDA is Earnings before Interest, Taxes, Depreciation and Amortization. The most common form of valuation in the middle market of M&A, particularly for businesses with at least $500,000 of EBITDA. Using transaction data relevant to the business and industry a multiple, say 4x is applied to the adjusted ebitda to come up with a price. The EBITDA multiple method is sometimes criticized because it does not consider taxes and capital expenditures. It is nonetheless an important method to use as a starting point for buyers, sellers and advisors. Different buyers will have different tax structures and investment requirements so the ebitda multiple method is a useful tool for business owners to determine probable offers to be received from buyers.
b) Multiple of EBITDA should be looked as a guide for possible offers from buyers rather than a specific numbers. As you can see from the chart of transaction multiples for the construction industry, multiples vary widely between the industry segments and even within each segment. Industry professionals experienced in the market can help fine
Multiple of SDE
a) Similar to Multiple of EBITDA, but SDE which stands for Sellers Discretionary Earnings, includes the owners normalized salary and benefits. This is most often used in small business transactions where the owner is the key manager and the buyer is likely to be an individual who will replace the owner. Multiples of SDE tend to be lower than multiples of EBITDA but the resulting value could be the same for many businesses.
Multiple of Revenue
a) Multiples of revenue are often quoted but almost never used by professional buyers except in some unique circumstances. Buyers and lenders are interested in cash flow much more than revenue. For instance, a manufacturer with $5 million in sales and $1 million of gross profit is going to be of much lower value than a company with $5 million in sales and $2.5 million of gross profit, yet a multiple of revenue calculation will show both companies as being of equal value. Therefore this method has little accuracy and value for business sellers.
The valuation of a business includes financial calculations, but other factors are also important including the number and type of potential buyers, terms, and the unique characteristics of your business. In business sales transactions, typically a method such as EBITDA multiple is used to determine a probable range of offers and the qualitative factors(management, customers etc.) are considered to determine where in that range the business is likely to fall.