One of the most common and widely utilized methods for valuing your business for sale is the Multiple of Discretionary Earnings method. This method establishes the business value by multiplying the seller’s discretionary cash flow by a calculated valuation multiple which is derived from a number of business, industry, market, and owner preferences factors.
The method is especially well suited for valuing owner/operator managed businesses whose purchase is driven by both economic and lifestyle considerations.
When a seller is contemplating their business exit strategy and eventual sale of their business, it is crutial for the business to have accurate and timely financial statements and position the financial statements for sale. What is meant by positioning the financial statements for sale is showing as much profit as possible and one should avoid paying any non essential expenses through their business (autos, meals, insurances, personal expenses).
To arrive at the sellers discretionary earnings, one would start by taking the net profit or loss on the income statement and add back items such as depreciation, interest expense, owner salary and other discretionary owner expenses. In addition to the above expenses one would add back any non recurring expenses which just may pertain to a one-time event. It is quite common to do this exercise for the most current year of operations and the two prior years. This will allow the seller a more accurate view of what the business is actually generating.
Once the discretionary earnings are calculated, that figure would be the basis for applying the valuation multiple of earnings.
In determining the valuation multiple there are 10 business risk characteristics that need to be assessed by applying a multiple range indicator to the risk characteristic and then applying a weighted average multiple to each characteristic. These characteristics are:
Stability of historical earnings
Business and industry growth
Type of business
Location and facilities
Stability and skills of employees
Diversification of products, services, and geographic markets
Desirability and marketability
Depth of management
Availability of capital/terms of sale
The application multiple range indictors and weighted averages can be subjective but it has been my experience that when both the seller and the buyer do their calculations and are informed and knowledgeable, that valuation multiple is not far off between the parties.
Now that the discretionary earnings and valuation multiple have been calculated just multiply one by the other to determine the value of the company’s operating assets. This valuation normally includes machinery, equipment, supplies, leasehold improvements, a normalized level of inventory and intangible assets. This capitalized value represents the estimated value at which many small businesses sell. It does not, however, represent the total value of the business.
If necessary, the value would be adjusted for net working capital, excess assets, non operating assets and company debt.
Finally a sanity check should be performed to determine the reasonableness of the estimated value.