Business Appraisal in an Hour!
his article is the shorter version of the five blog posts of April 3-7, 2009 at GlenCooperBlog.com, hosted by Maine Business Brokers.
There is a simplified method for appraising most businesses. Key terms are important to understand. Major exceptions must be noted. This short-cut method is useful because it can give you a general idea of what a business might be worth. Attention must also be paid the non-financial aspects of business valuation. (See also the companion article “Value Drivers of Business Sales.”) Business values are influenced by many factors besides just earnings.
Warning: any figure derived by using a simplified multiple of earnings won't be exact. Also, this specific method doesn't apply to the larger businesses with sales over, say, $5 million. It doesn't apply to businesses like motels, hotels, campgrounds and marinas, where real estate values are such major elements.
So, What's the Method?
This short-cut method comes from the use of comparable data from businesses that have sold. As messy as this data often is, in its aggregate form, it offers surprising clarity.
In the last 30 years, three major databases have been developed: BizComps,® Pratt's Stats®, and the database of the Institute of Business Appraisers (IBA). The business sales they contain have proven to be reliable barometers for business valuations.
From the business sales in these databases, earnings multiples can be derived. The most common is a multiple of "cash flow to the owner," an expression of earnings that BizComps® labels "Seller's Discretionary Earnings," or SDE.
SDE is calculated by taking EBITDA and adding owner's salary. EBITDA is "earnings before interest, taxes, depreciation and amortization," a common earnings definition. Technically, SDE also calls for the adding back of all non-cash, non-operating and non-recurring expenses, as well as income taxes paid, but for most small businesses, these are either obvious, inconsequential, and/or illegal for you CPAs and we brokers to even know about, so we are ignoring them here.
SDE, or owner's cash flow, is thought to be a more appropriate measure of earnings for smaller businesses. EBITDA is used mostly to measure earnings of the so-called "mid market" businesses - those with professional management separate from ownership.
What the historical sales of businesses show (consistently over the last 30 years, believe it or not!) is that small businesses tend to sell for between 1.5 and 3.5 times historical SDE, not including inventory for resale, and/or real estate.
Before we go on, however, let’s be clear that we understand that “SDE” is a specific level of earnings, not to be confused with “EBIT,” “EBITDA” or other levels. The multiples are different when applied to different levels of earnings. The earnings multiple goes higher when using EBITDA, and higher still with EBIT. Part of the reason this is so confusing is that business publications and Internet writings are often incorrect in their use of this data. Remember, also, that this DOES NOT apply to the real estate and/or to businesses which are comprised of mostly real estate assets, like motels, hotels, golf courses or campgrounds.
Even if we all agree to be consistent about the level of earnings we use, the data is still messy. Because of this messiness, a simple-to-understand multiple of 3x SDE (3 “times” the annual SDE) is often used in business pricing. This multiple, which might be a little high for some businesses, is a good starting point for an asking price. It is at the high end of the historic range, so business owners frequently choose it as the “starting point” for their business pricing.
What About . . . ?
At this point, nearly everyone asks questions that begin with, "But, what about . . . ?" Before we can properly answer any of these questions, we need to provide just a little more basic detail.
When calculating EBITDA, the databases use "the most recent reporting period." In actual practice, however, buyer prospects are usually thinking ahead of what the future will hold for them. What the current owner did last year is not as important as what's happening now, and what estimates the buyer makes of future cash flows.
For the "owner's salary," there is not only the adjustment for formal salary, but also for other owner benefits. To obtain uniformity of the data, there is a requirement of adjusting the expenses back to just one owner. If multiple owners run a business, these adjustments can get pretty tricky.
Within the multiple-derived price, the business' furniture, fixtures and equipment are included, along with all intangible assets. In most cases, the owner's personal vehicle is not included.
Real Estate Included?
Real estate is NOT included in the multiple-derived value; so, if real estate is going to be part of the valuation, we need to add it. Inventory and work in process values also need to be added at the lesser of cost or wholesale market price.
Two other major points need to be made about this multiple-derived value: accounts receivable are not included, nor is any accounting made of possible company debt. Accounts receivable are most often retained by sellers, collected in the transition period following a sale. They are rarely sold.
This formula also assumes a debt-free business. Existing business debt obviously must be subtracted from the value estimate to arrive at a net figure for the seller. In addition, if a buyer assumes debt when buying, it is counted as part of the purchase price in this model.
What is, or isn't, included in the formula or multiple-derived value depends, of course, upon the definition of value. To keep this simple, we have chosen to use the BizComps® sales price definition.
BizComps® separates the reported business selling price from the sale of inventory and real estate. If we say, for example, that a business is worth "3 x SDE," it is because there are many comparative transactions to show that businesses often sell for prices which reflect this multiple.
This "3 x SDE," then becomes our quickest ballpark estimate of business "value." We use it cautiously before completing any further homework to refine our estimate.
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