Business Valuation: More than “Multiples of Earnings”
With business brokerage activity hitting a 5 year high it’s not uncommon for us to encounter business valuations generated by an inexperienced professional. Whether an accountant who primarily does taxes, a real estate professional dabbling in business brokerage , an investment professional more familiar with passive investments, or a successful business person who has bought or sold a business in the past, they may be valuing a business without analyzing several critical factors. Over valuing a business could have a material impact on the salability of the business and alienate a qualified buyer, and undervaluing a business impacts the seller and deprives him of the proper return on his time and investment.
The problem lies on the over reliance of using simple valuation “rules of thumb”—primarily multiples of earnings and multiples(or percentages) of gross sales. Using these multiples is an expedient method of deriving a quick valuation range but it should be clear that these rules of thumb are simplified tools for more complex valuation factors.
In general, passive investments(stocks, bonds, etc) are valued using four variables: the expected earnings of the investment, the time period of the earnings, the value of money(discount rate) and the volatility risk of the investment(Beta or β). While a passive investment in a publicly traded security is far different than an owner operated “going concern”, these same four variables should be examined to properly value a business. In fact, earnings multiples are an abbreviated version of that formula. However, there are several other intangible factors that have a material impact on the salability and final valuation of a business that may not be addressed in passive investment decisions.
1. Value Drivers. I’ve written several times about “Value Drivers”: qualitative aspects of a business that makes it more or less appealing to a buyer. In the way that earning multiples simplify more involved value computations, value drivers describe consumer preference theory and the “indifference curve” in microeconomics. This theory examines consumers’ choices between different “bundles” of goods—in this case the choices are different businesses. Unlike stocks and bonds whose investment choice is driven by expected ROI and portfolio allocation, owner-operated businesses are almost always bought and sold based on consumer preferences.
2. Social Trends. Often fundamentally irrelevant to the investment opportunity, social trends can often drive the attractiveness (and thus price) of certain businesses. These social trends will often lead to “bubbles’ in certain market segments—price inflation of certain businesses due to a perception of likely success or an increase in social standing. Unpopular businesses or industries may need to be priced at a discount to attract buyers.
3. Supply. Using the internet, business buyers are easily able to find, compare and analyze hundreds of businesses. Supply is not simply the number of businesses for sale, but the type, quantity and terms of the listings. Your business will be compared to other listings—and not just on the cash flow to price(the earnings multiple). All else being equal, different businesses that have the same cash flow and price will be selected based on other qualitative variables. If your business lacks “appeal” the price will need to be adjusted from the simple multiple valuation.
What does all this mean? In short, deriving your business’s value purely from a simplistic earnings multiple may not reflect the “Market Value” of the business. The “Market Value” should include the real price effects of value drivers, social trends and supply of other businesses on the market. Mispricing a business from the outset can cost you finding the right buyer.
