Have you ever asked yourself, “I wonder how much my business is worth?” or “How much could I sell my business for?” Both are valid questions; and whether or not you are trying to sell your business, having a good idea of your business worth can help you to make better financial decisions.
Professional Business Appraisals are the Most Accurate
The most accurate method to determine how much your business is worth is to get a business appraisal by either a Certified Valuation Analyst, a Certified Public Accountant, or a Certified General Real Estate Appraiser (both specializing in business appraisals). A professional business valuation will determine the value of both your tangible and intangible assets. They will carefully examine your financial records and make appropriate adjustments to create a starting base of calculation. They will then apply several nationally-approved valuation methods to determine the value of your business.
How Much Does a Business Appraisal Cost?
The downside to such a professional business valuation is that they are not cheap. A preliminary analysis that creates a ball-park estimate, often to start a sales negotiation, can cost between $3,000 to $10,000 depending on the complexity of the business. A comprehensive summary appraisal report, which is the most common business valuation, will range between $5,000 and $35,000. These valuations can be used in court, contract disputes, and other situations where a detailed and highly accurate business valuation is critical.
But what if you just want a general idea of how much your business is worth?
Market-based Business Valuation Multipliers Can Help
A business valuation multiplier can be applied to financial records to determine a sales price or business worth. The multipliers are determined by comparing the sales price of a business to a derivative of the net operating income. For example, the rule of thumb for fast food restaurants is 2 to 3 times EBIT or 2.5 to 3.5 times EBITDA and 1.5 to 2.5 times SDE plus inventory.
What is EBIT, EBITDA and SDE?
The challenge in using a multiplier starts with the business income. What if one fast food restaurant provided financial statements that included their mortgage payments; another subtracted their mortgage payments but included the building and equipment depreciation; and a third removed the owner’s income and all expenses not associated with the direct operation of the business. If all three businesses had the exact same adjusted net operating income, there should be three completely different business values. A single multiplier would not be accurate.
For a business valuation multiplier to work, the financial statements must be standardized.
EBIT, EBITDA and SDE are acronyms for standardized financial statements.
- EBIT – Earnings Before Interest and Taxes. By not including any mortgage payments, loan interest expenses, or income taxes, an investor can better gauge the profitability of a business without factoring the current owner’s financial arrangements.
- EBITDA – Earnings Before Interest, Taxes, Depreciation and Amortization. This is the most recognized accounting metric used to evaluate a company’s operating performance. Since the purchase of the tangible assets resets the depreciation schedule, it is appropriate that a business valuation does not include depreciation. The amortization mentioned here is not mortgage payments (which are not included under EBIT to begin with) but rather cover the amortization of capital expenditures related to intangible assets like franchise rights or patents.
- SDE – Seller’s Discretionary Earnings. This includes all of the net operating income available to a full-time owner/operator after all direct business-related expenses are removed. It does not include any salaries or benefits paid to the owner, one-time business expenses or depreciation.
If you want to learn more about these standardized financial statements, please check out our article Understanding EBIT, EBITDA, and SDE for Small and Medium-Sized Business Valuation. Suffice it to say, if the financial records are not completely accurate and in full harmony with the terms of the acronym, then the business value based on a multiplier will not be anywhere close to accurate.
How are Business Valuation Multipliers Calculated?
The key factor in creating an accurate business multiplier is in locating a verifiable pool of data. Researchers scour databases and contact business brokers and business owners to locate recent sales and then class them into their respective categories. The financial statement methodology is verified and then the ratio is calculated by dividing the available EBIT, EBITDA and SDE into the sales price. For example, if a fast food restaurant sold for $1.2 M and it had an EBITDA of $400,000, then the multiplier would be 3 times the EBITDA.
The problem here is that each business within a specific category is different. This is especially true for non-francized mom-and-pop businesses. Management styles differ. Modernization, or the lack of it, impact sales. The localized economy also plays a very large role. While the effect of each of these factors is contained within the net income, it is extremely difficult to quantify.
The success in a business valuation multiplier lies in locating huge pools of similar data.
The only way to “normalize” a business category is to have a pool of hundreds or even thousands of sales. When this happens the median value in the total range will reflect less and less the impact of non-typical businesses within the general category.
Business Valuation Multiplier Warning
Just as an accurate business valuation must be based on an accurate financial statement, so it is with a business valuation multiplier. An off-the-cuff, market rule of thumb or “best guess” may significantly overvalue or undervalue your business – with serious ramifications when it comes time to sell.
The only way a business valuation multiplier can be accurately used to determine the value of your business is if the data pool was verifiable, applicable and extensive. This is going to require more than a grouping of ten or so similar business around the market area that recently sold. A good business valuation multiplier should incorporate national data accumulated by a highly respected group of analysts.
In next week’s article, we are going to give you some hard-core data for a broad array of business categories provided by a highly respected source.