How Businesses Are Valued


Valuation Methods


There are many methods of arriving at a value for business. A maxim in appraisal work says that the value is what a buyer would pay a seller with neither of them having any pressure to sell or buy. If this were true, there probably would not be any sales. So keep in mind that prices are determined by a willing buyer and a willing seller.

The reaction of the market place finally places a price on the business. Regardless of what a seller, business appraiser or broker comes up with – the marketplace ultimately determines what the business will sell for.

Valuation most used are:

Seller’s Discretionary Earnings (SDE)


This is the official name for a method that is becoming more popular not only as a pricing method, but also for valuing small businesses. Technically, it is a method that falls under the Earnings Approach. However, it is so popular a method for business brokers that it has several different names. For example: Seller’s Discretionary Cash, Owner’s Cash Flow, Owner’s Benefit, and various other names.

The reason for the name is that the method is based on the total cash flow of the owner, including salary, benefits, depreciation – all items that are benefits to the owner, or discretionary items. All of this is then added to the profit of the business to arrive at a grad total of the owner’s cash flow.

There are actual and real expenses that are necessary to the operation of the business such as: rent, utilities, labor, etc. There are expenses that the owner has control over such as: auto expense, salary (his or hers), owner benefits and the like. Then there is depreciation and amortization that are non-cash items.

The Seller’s Discretionary Earning Method strives to measure the economic and lifestyle characteristics perceived by those who buy and serve as owner/operators of small to midsize businesses.

Sellers Discretionary Earnings – Owners Benefit - (Method One)


Step One
Calculate the discretionary or real cash flow of the business from the profit and loss statement.

Step Two
Multiply the result of Step One by a multiplier. Most businesses seem to sell for 1.8 to 2.2 times the Sellers Discretionary Earnings

(Note that debt service does not play a part in this method).
Example:

Seller’s Discretionary Cash Flow ……………………………….$85.000

Ice cream store multiplier (for example); …………………….....2.1

Multiply (1) by 2.1 to arrive at suggest selling price: …….…….$178,500

Asset/Based (Method Two)


Here are the steps:

1. Prepare a reconstructed balance sheet showing the reported assets and liabilities

2. Add any assets needed to operate the business, but not shown on the reported balance sheet.

3. Adjust the balance sheet to reflect Non-Operating Assets and Liabilities

4. Determine the market value of the tangible assets and liabilities to be included in a sale. Sources of this information can be found by contacting used equipment dealers and/or auctioneers.
This method is best used for real estate holding companies or asset heavy companies with earnings that do not support a value higher than the tangible assets. The latter may indicate that the company may only be worth the liquidation value of its tangible assets. This method is often used even with profitable companies to represent the low end of the range of indications of value, and sets the hurdle that valuation methods based on earnings must overcome to show proof of goodwill value.


Capitalized earnings


This method simply uses a rate of return the prospective buyer of a business feels he/she needs to justify the purchase of the business. If a buyer can get 6-8% from a very safe, risk-free investment, what is the buyer entitled to for the risk of business ownership?
Step One
Calculate the pretax earnings of the business from the profit and loss statement. Eliminate non-operating income and related expenses.

Step Two
Subtract reasonable manager or owner salary.

Step Three
Subtract the economic depreciation of assets (the annual cost of replacing them), and non—recurring expenses.

Step Four
Determine a fair rate of return that a buyer should receive for investing in the business. Step Five
Convert the percentage into a multiple by dividing it into 100.

Step Six
Multiply the result of Step 1 less Steps 2 and 3 by the result of Step 5 to arrive at the suggested sale price.
Note: Most appraisers use a capitalization (cap) rate; not a multiplier. The typical range of cap rates is 16% to 50% for pretax earnings. Most appraisers derive the cap rate from a discount rate based on the cost of capital.

Example:

Seller’s pre tax earning: .............................................................. $85,000

Subtract reasonable salary for manager or owner................. ($85,000 - $35,000 = $50,000

Subtract depreciation and non-recurring expenses............... ($50,000 - $10,000 = $40,000 )

Risk-free investment return (US Treasury rates, etc.): ………6%
    + additional return for risk of business ownership: ………10%
    + additional return for risk of small business ownership: .16%

Divide 32% (6% + 10% + 16%) into 100 to arrive at cap rate..... 3.13

Multiply by 5 to arrive at a suggested selling price of: ………$125,200

This method may work best for larger businesses.

Other Valuation Inputs Businesses that are franchises will command a higher price than a similar stand-alone business. Example “McDonald” vs. local hamburger eatery. Also the geographic area in the country will add or subtract value based on growth or decline in the population area. Desirable areas such as Southwest Florida will ad 10% to 15% to the normal value of a business.

1. Footnote: Some of this information was referenced from the book “The 2004 Business Reference Guide” by author Tom West.

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