Demystifying Small Business Valuation
Valuing a business is based on return on your investment (ROI). The value of a Business for Sale does not need to be subjective and can be based on several attributes and industry best practices.
Approach to Business Valuation
Valuing businesses is of paramount importance to a small business. It is one of the several metrics used to ensure the business is growing and creating value for the owners. There are several approaches to valuing a business including:
• Revenue Multiples
Earnings Multiples (including EBITA and operating income)
• Multiple of Book Value
Multiple of a measured unit (Like Restaurant tables, hospital beds, subscribers and more)
Rules of thumb are used by business brokers to ascertain the price of a business and simplify the valuation process. However, one must be mindful that the values determined using “Rule of thumb” are simplifications and only an estimate of the true value of the business. The “Rule of thumb” approach is used as a staring point before conducting detailed due-diligence to ascertain the correct value. Some examples of “Rules of thumb” used in the industry are listed in Table 1 below:
Table 1: Rules of Thumb Valuation
Type of Business “Rule of Thumb” valuation
Book Stores 15% of annual sales + inventory
Coffee Shops 40% - 45% of annual sales + inventory
Food/Gourmet Shops 20% of annual sales + inventory
Gas Stations 15% - 25% of annual sales + equip/inventory
Restaurants (non-franchised) 30% - 45% of annual sales
Dry Cleaners 70% - 100% of annual sales
A common approach to valuing a business is to use earnings or sales multiples. In this case since the price it is derived from annual earnings or sales and it directly addresses a buyer’s motive of estimating the return on investment (ROI) on deals.
When using earnings multipliers, it is inappropriate to get the multiples from Real Estate or Stock Markets. Real Estate is historically priced at 8 to 10 times its net operating income (EBITA). Stock markets are typically priced at 12 to 20 times earnings. These multiples do not apply to small businesses as the risk premium associated with a small business is much higher than managing a building or a stock portfolio.
Therefore, the first step in using the earnings multiplier approach is to determine which earnings multiplier is to be used. For example, one could use the current earnings, next year’s earnings or last 5 years earnings averaged. Other factors to consider include determining the composition of earnings. Do we need to calculate earnings after owner’s pay and perks, interest expenses, depreciation and taxes? The preferred earnings to use are 'Earnings before Interest and Taxes’ (EBIT).
Normalized earnings are adjusted for cyclical ups and downs in the economy. They are also adjusted for unusual or one-time influences. For small businesses normalized earnings projections are quite useful.
Finally we need to determine the multiplier. The number picked for multiplier is based on risk and there usually are “Rules of Thumb” multiplier numbers depending on the industry.
Using a multiplier with annual sales is also a common approach. For example, the “Rule of thumb” for a coffee shop is 40% - 45% of annual sales + inventory.
Tangible and Intangible assets
A tangible asset is an asset that has a physical form such as land, buildings and machinery. Intangible assets are the opposite of tangible assets. Intangible assets include patents, trademarks, brand value etc. Tangible and intangible assets raise interesting questions when valuing a business.
Typically once the value of the business itself has been ascertained, we need to factor in a value for Tangible and Intangible assets. These assets usually have a value separate from the business. One way to determine if an asset should be included as a tangible/intangible asset or included in the price for the business is to determine if the asset was used to generate the projected earnings. If the asset was used to generate earnings it should be included as a part of the multiple derived price of the business.
Factoring in tangible assets separately is especially true for businesses that own land and buildings, as these assets can be sold in the market even if the business failed. Therefore the best way to treat tangible/intangible asset is to separate them from the business and then add them back to the multiple derived value of the business. Obviously during the valuation period, asserts should not be counted twice. For example if the building has been factored out as a tangible and intangible asset, then rent for the premises must be subtracted from the business earnings. Similarly inventory impacts the business value. Typically inventory is valued at cost and treated as a tangible asset.
Earnings Multiples
After the value of tangible and intangible assets is determined we need to determine the value of the business using the correct multiples. Multiples used are very specific to a business and location of the business but broadly speaking it can be between 2 to 5 times normalized EBIT (Earnings before Interest and Taxes). The business can be worth more if it is has distinctive attributes that make it very attractive. To the buyer, 2 to 5 times earnings represent getting back their investment in the business in 2 to 5 years from profits a projected annual return of 20% to 50%.
Eventually the right multiple is the amount the buyer is willing to pay for the business. A business can demand higher multiples by clearly defining a case to increase earnings over time.
Disadvantages and caveats
Based on the content covered earlier, you may wonder how one can be certain the business valuation is perfect for the business buyer and seller. In reality there is no perfect price and techniques described in the earlier sections are just guidelines to derive an acceptable price.
The multiplier approach discussed does not provide sufficient information to assess the uniqueness of the business, such as management depth, customer relationships, industry trends, reputation, location, competition, capital structure and other information unique to the business. Further, two businesses of the same type and same revenue can have different cash flows.
The rules for evaluating a business are more of guidance then a hard and fast rule. They should be thought of as a starting point which can be further refined by factors specifically impacting the business. Proper evaluation will go beyond calculations based on multiples and tangible/intangible asset values. It requires complete business, marketing and financial due-diligence. However the approach describes in this article can play a key role in determining a starting value of your business.
Sites such as http://www.buysellbusiness.org allow entrepreneurs to do deals by buying and selling businesses and partnering. When researching businesses for deals, these guidelines can play an important role in quickly calculating the intrinsic value of a business.
http://www.buysellbusiness.org/BusinessTools/BizValuations.aspx
