Earnings Multiple: A Valuation Method

 

Earnings Multiple: A Valuation Method

Among various methods for determining the value of a small business, the "earnings multiple" approach is almost universally considered to be the most acceptable and useful.

 

Those brokers in favor of the asset appraisal method believe the easiest and most accurate way to decide on a company's worth is simply to arrive at a sum by adding up the dollar value of all its assets. A machine shop--for example-- with its lathes, drills, stamping and milling machines should be worth what it would cost to purchase all of this equipment, plus the supplies and materials required for the machine shop operations.

 

Meanwhile, market comparable advocates, many of whom have a background in real estate sales, take the position that if you want to know what a business is worth, it's necessary only to find out the selling prices for other businesses that are similar to the one under study. That is, after all, the most popular way to figure out a price at which to sell a home. And this same valuation theory will be used by the appraiser hired by the bank considering a loan request from a would-be purchaser.

 

Unlike a home, however, a small business is not likely to have much in common with other businesses in the area, even those in the same industry. Operations affiliated with the same franchise company, and in neighboring communities, would seem to have much in common, and yet are rarely comparable. There will be differences in business volume, rent paid and other factors that influence profitability. The result is that when the two businesses go to market, they will bring different selling prices. This fact has been proved repeatedly by owners of multiple operations affiliated with a single franchisor, and located in neighboring communities. An added problem with this method is the dollar value of a business sale is not a matter of public record. Most everyone who is interested can find out the amount that was paid for the two-story Tudor style house on Main Street. But the prices recently paid for the restaurant, gas station and dress shop are not posted anywhere that can be viewed by the public. A business appraiser wanting to use the "market-comparables" system is at a distinct disadvantage because the information needed to establish a valuation is not available.

 

A MONEY MACHINE

 

The essential idea behind the earnings multiple valuation system is that a business is a mechanism for making an income--it's value a direct function of the amount of that income. The size of that "machine," the value of the equipment used to produce the income, the similarity with other businesses--these all are interesting facts, but not the determining factor when deciding what a company is worth. A machine shop, for example, may have assets with a value in the hundreds of thousands of dollars. But if, according to the "money machine" principal, it does not generate hundreds of thousands in earnings to the seller, it's value as a going entity will be less than the amount that could be raised by selling off its equipment. A seller whose company has more "scrap" value (measured by what the company's pieces would sell for) than "earnings" value might yield a better price by auctioning off the assets one by one.

 

An example often repeated by business brokers and small business valuation professionals describes a comparison between--

• on the one hand--a manufacturing company in a troubled industry with several hundred thousands in hard assets, but less than $3,500 per month in owner earnings, and
• on the other hand, a distributorship generating more than $20,000 per month in owner earnings, and operated successfully with little in the way of assets--perhaps just a fax-capable telephone and an address book.

 

The comparison is cited as a valuation problem to solve, posed as "which is more valuable as a going business?" and the right answer, of course, is the distributorship.

 

This and other examples serve to remind prospective buyers and sellers that most people in the market to buy a small business are seeking healthy cash flow. The multiple used in the formula may vary, based on the industry standard, but the valuation method of choice is almost always dependent on owner earnings.

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