Business Valuation Methods in a Nutshell - Morgan & Westfield (2024)

Executive Summary

Pricing a business is based primarily on its profitability. Profit is the number one criteria buyers look for when buying a business and the number one factor that buyers use to value a business.

There are other variables that buyers may consider, but the majority of buyers exclusively look for one thing: profit.

Other terms for profit include the following:

• Earnings before Interest, Taxes, Depreciation, and Amortization (EBITDA). This is the most common term used by M&A intermediaries and investment bankers.
• Seller’s Discretionary Earnings (SDE). This is the most common term used by nearly every broker, as well as buyers who deal with brokers.
• Seller’s Discretionary Cash Flow (SDCF). SDE replaced this as the preferred metric by the International Business Brokers Association.
• Cash Flow. This is a general term that can refer to a variety of cash flow measures.
• Net Income. Sales minus the cost of goods sold, general expenses, interest, and taxes.

There are two primary ways to value a business:

• Method #1 – Multiple of SDE or EBITDA. Multiply the SDE or EBITDA of the business by a multiple. Common multiples for most small businesses are two to four times SDE. Common multiples for mid-sized businesses are three to six times EBITDA.
• Method #2 – Comparable Sales Approach. This involves researching prices of similar businesses that have sold and then adjusting the value based on any differences between your company and the comparable company.

Ready for a deep dive? In the following sections, we go into detail about the two primary methods you can use to value your business.

Business Valuation Method #1 – Multiple of SDE or EBITDA

Here’s how you can value your business using the multiple of earnings method:

Step 1: Determine the cash flow (SDE, EBITDA) for the previous 12 months or your latest fiscal year. This is called “recasting” or “normalizing” the financial statements. It involves adding the following back to the net profit of your business: depreciation, amortization, owner’s salary, non-cash expenses, non-recurring expenses, and other perks.

Step 2: Multiply your business’s cash flow by the multiple.

Example: $1,000,000 EBITDA (Cash Flow) x 4.0 Multiple = $4,000,000 Value of Business

Common Multiples

Here are common current multiples for businesses with less than $5 million in annual revenue:

• Retail businesses: 1.5 to 3.0 (i.e., cash flow x 1.5-3.0 multiple)
• Service businesses: 1.5 to 3.0 (i.e., cash flow x 1.5-3.0 multiple)
• Food businesses: 1.5 to 3.0 (i.e., cash flow x 1.5-3.0 multiple)
• Manufacturing businesses: 3.0 to 5.0+ (i.e., cash flow x 3.0-5.0+ multiple)
• Wholesale businesses: 2.0 to 4.0 (i.e., cash flow x 2.0-4.0 multiple)

Here are common current multiples for businesses with $5 million to $100 million in annual revenue:

• Retail businesses: 3.0 to 5.0 (i.e., cash flow x 3.0-5.0 multiple)
• Service businesses: 3.0 to 5.0 (i.e., cash flow x 3.0-5.0 multiple)
• Food businesses: 3.0 to 4.0 (i.e., cash flow x 3.0-4.0 multiple)
• Manufacturing businesses: 3.0 to 6.0+ (i.e., cash flow x 3.0-6.0+ multiple)
• Wholesale businesses: 2.5 to 5.0 (i.e., cash flow x 2.5-5.0 multiple)

Note: Multiples vary with the current economic climate and market conditions. How do you determine the appropriate multiple? Unfortunately, this can only come from experience; however, the guidelines above can be a helpful starting point.

Multiples for Larger Businesses

Most mid-sized businesses are priced at three to six times EBITDA. The multiple varies based on several factors, primarily the industry that a business operates in.

Larger businesses always sell at higher multiples. To demonstrate:

• Business A: Cash flow (SDE) of $100,000 per year = 3 multiple, or asking price of $300,000.
• Business B: Cash flow (EBITDA) of $5 million per year = 5 multiple, or an asking price of $25 million.
• Business C: Cash flow (EBITDA) of $100 million per year = 8 multiple, or an asking price of $800 million.

The relationship between cash flow and multiples is direct. As the cash flow or EBITDA of the business increases, so does the multiple. Larger businesses are seen as more valuable by sophisticated investors because they are viewed as more stable, have more professional management teams, and are less dependent on the owner for the business to operate. This is a simple, clear relationship between the size of a company and its multiple that is demonstrated in the transactional databases and widely accepted by both intermediaries and buyers alike.

What is the Difference Between SDE and EBITDA?

SDE and EBITDA are often loosely used terms. SDE includes the owner’s or manager’s salary (it’s added back when calculating SDE), while EBITDA deducts a reasonable amount from the cash flow to pay a full-time manager to operate the business.

For example:

Net Profit $1,000,000

Manager’s (Owner’s) Salary $200,000

SDE = $1,000,000 + $200,000 $1,200,000

EBITDA = $1,000,000 – $200,000 $800,000

SDE is the most commonly used metric when an individual is buying your business.

EBITDA is most commonly used when a company is buying your business.

Why?

Individuals looking to buy businesses will usually operate the business themselves and will not need to pay a manager to run the business.

Companies must usually employ a full-time manager to replace the current owner and must deduct this from the available cash flow.

Business Valuation Method #2 – Comparable Sales Approach

The comparable sales approach is a method for pricing your business based on the prices of similar businesses sold, then making adjustments to account for any differences between your company and the subject (comparable) company.

This approach is often difficult to use because the prices of businesses are not public records, which is why the range of potential values for a company can be so wide. The best source of comparable transactions is from a business broker, M&A intermediary, or business appraiser who has access to private databases. There are three or four databases with comparable business sales. However, the information is sparse or incomplete, so you can’t rely on this data entirely. Collectively, these databases contain approximately 100,000 transactions.

Other Factors to Consider When Valuing a Business

Value Enhancement

There are only two direct ways to increase the value of your business:

1. Increase the Cash Flow (SDE, EBITDA): One is by increasing cash flow (SDE, EBITDA). There are only two ways to increase the profitability of your business:
   1. Reduce expenses.
   2. Increase revenues.
2. Increase the Multiple: The second way to increase the value of your business is by increasing your multiple. Multiples are based on several factors, including:
   1. Risk: Your multiple is a reflection of how risky a buyer perceives your business to be. To increase your multiple — and your valuation — you should take steps to reduce the risks associated with your business.
   2. Recurring Revenue: Businesses with recurring revenue will attract higher multiples.
   3. Growth Strategy: Buyers will pay higher multiples for companies that have a realistic growth strategy.

Accounting for Synergies

The valuation methods above do not take into account possible synergies that might be achieved. The value of synergies is impossible to calculate without knowing who the buyer is and having access to their financial statements. The value of synergies is also different for every buyer; therefore, the value of your business can differ substantially depending on who the buyer is.

There are five types of synergy calculations: cost savings; revenue enhancement; process improvements, financial engineering (e.g., cheaper access to debt); and tax benefits.

Pricing a Business that’s Losing Money

Let’s say you have a manufacturing business that is breaking even, but you invested $1 million in it. Surely, it has to be worth what you put into it, right? It’s unlikely.

Most buyers are industry agnostic and will usually consider buying a business in a variety of industries. For this reason, the price of your business must be competitive given the buyer’s reasonable alternatives.

Note: This formula is not true if the buyer is interested in buying your specific type of business, such as an IT staffing company. However, less than 5% of buyers want only one type of business. We don’t recommend that you sell your business based on exceptions.

The price of your business must be competitive with other investment alternatives available to buyers. Imagine you’re a buyer — which of these businesses would you buy?

• Business A: Asking $5 million — The business is breakeven.
• Business B: Asking $5 million — EBITDA is $1,500,000.

What buyers look for: The answer is obvious: 99% of buyers will purchase Business B. Always keep in mind that the number one thing buyers look for in a business is profit — specifically the ratio between the asking price and EBITDA — or the multiple.

Why are there businesses for sale that aren’t profitable?

Because they aren’t profitable.

Yes, they are for sale, but they have not sold. Why do you think you don’t see many businesses priced right that are still on the market? It’s because they are sold — because they were priced right. The fact is that 80% to 90% of businesses are probably overpriced, so don’t let the fact that there are overpriced businesses on the market deceive you.

FAQs

What should the price include?

The price should include all tangible and intangible assets used in the business to generate the cash flow the business produces. This includes all of the equipment and assets required to operate the business on a daily basis.

Should inventory be included?

This is a common debate among experts. You can try to get paid for the inventory in addition to the price. It’s going to be negotiated anyway, so ask for it upfront and see what happens.

Conclusion

Pricing a business is based primarily on its profitability. There are other variables that buyers may consider when purchasing a business, but the majority exclusively look for one thing: profit. When valuing your business, focus on the two methods most buyers use to value a business:

1. Multiple of SDE or EBITDA.
2. Comparable Sales.

To increase the value of your business, focus on increasing your EBITDA or increasing your multiple.