How Businesses Are Valued
The reaction of the market place finally places a price on the business. Regardless of what a seller, business appraiser or broker comes up with – the marketplace ultimately determines what the business will sell for.
Valuations most used are:
Seller’s Discretionary Earnings (SDE)
This is the official name for a method that is becoming more popular not only as a pricing method, but also for valuing small businesses. Technically, it is a method that falls under the Earnings Approach. However, it is so popular a method for business brokers that it has several different names. For example: Seller’s Discretionary Cash, Owner’s Cash Flow, Owner’s Benefit, and various other names.
The reason for the name is that the method is based on the total cash flow of the owner, including salary, benefits, depreciation – all items that are benefits to the owner, or discretionary items. All of this is then added to the profit of the business to arrive at a grand total of the owner’s cash flow.
There are actual and real expenses that are necessary to the operation of the business such as: rent, utilities, labor, etc. There are expenses that the owner has control over such as: auto expense, salary (his or hers), owner benefits and the like. Then there is depreciation and amortization that are non-cash items.
The Seller’s Discretionary Earning Method strives to measure the economic and lifestyle characteristics perceived by those who buy and serve as owner/operators of small to midsize businesses.
Sellers Discretionary Earnings – Owners Benefit - (Method One)
Calculate the discretionary or real cash flow of the business from the profit and loss statement.
Multiply the result of Step One by a multiplier. Most businesses seem to sell for 1.8 to 2.2 times the Sellers Discretionary Earnings
(Note that debt service does not play a part in this method).
Seller’s Discretionary Cash Flow ……………………………….$85.000
Ice cream store multiplier (for example); …………………….....2.1
Multiply (1) by 2.1 to arrive at suggest selling price: …….…….$178,500
Asset/Based (Method Two)
Here are the steps:
1. Prepare a reconstructed balance sheet showing the reported assets and liabilities
2. Add any assets needed to operate the business, but not shown on the reported balance sheet.
3. Adjust the balance sheet to reflect Non-Operating Assets and Liabilities
4. Determine the market value of the tangible assets and liabilities to be included in a sale. Sources of this information can be found by contacting used equipment dealers and/or auctioneers.
This method simply uses a rate of return the prospective buyer of a business feels he/she needs to justify the purchase of the business. If a buyer can get 6-8% from a very safe, risk-free investment, what is the buyer entitled to for the risk of business ownership?
Calculate the pretax earnings of the business from the profit and loss statement. Eliminate non-operating income and related expenses.
Subtract reasonable manager or owner salary.
Subtract the economic depreciation of assets (the annual cost of replacing them), and non—recurring expenses.
Determine a fair rate of return that a buyer should receive for investing in the business. Step Five
Convert the percentage into a multiple by dividing it into 100.
Multiply the result of Step 1 less Steps 2 and 3 by the result of Step 5 to arrive at the suggested sale price.
Note: Most appraisers use a capitalization (cap) rate; not a multiplier.
The typical range of cap rates is 16% to 50% for pretax earnings.
Most appraisers derive the cap rate from a discount rate based on the cost of capital.
Seller’s pre tax earning: .............................................................. $85,000
Subtract reasonable salary for manager or owner................. ($85,000 - $35,000 = $50,000
Subtract depreciation and non-recurring expenses............... ($50,000 - $10,000 = $40,000 )
Risk-free investment return (US Treasury rates, etc.): ………6%
+ additional return for risk of business ownership: ………10%
+ additional return for risk of small business ownership: .16%
Divide 32% (6% + 10% + 16%) into 100 to arrive at cap rate..... 3.13
Multiply by 5 to arrive at a suggested selling price of: ………$125,200
This method may work best for larger businesses.
Other Valuation Inputs Businesses that are franchises will command a higher price than a similar stand-alone business. Example “McDonald” vs. local hamburger eatery. Also the geographic area in the country will add or subtract value based on growth or decline in the population area. Desirable areas such as Southwest Florida will ad 10% to 15% to the normal value of a business.
1. Footnote: Some of this information was referenced from the book “The 2004 Business Reference Guide” by author Tom West.