Rules of Thumb with Small Business Valuations
To help price the business before, during and after sale, business brokers as well as other professional intermediaries will implement certain rules of thumb into the valuation process.
Although these rules are gross simplifications, they do however provide a general idea of a suitable price range for the business.
Using some type of earning multiplier makes the most sense if a rule of thumb is to be used when valuing a business. This will address the buyers most lightly motive to achieve a return from the investment. It’s important to remember that sales multiples mean nothing unless they can be translated into profits.
Let’s consider two major areas of confusion that are inappropriate comparisons to invest Real Estate or Stock Market Earnings Multiples.
Real Estate is often found to be priced eight to ten times its net operating income. Whereas Stock Market Prices are often found to be more than 20 x earning often due to (valuations being based on future earnings)
Due to the higher risk when investing in small, privately owned business, we can’t use those valuation rules of thumb mentioned in the previous paragraph (Real Estate & Stock Market Prices). Business have lower liquidity not to mention there’s a lot more work involved in running a small business when compared to managing a stock portfolio or office building.
If we are to determine an applicable earnings multiplier, we need to ask the following questions:
What are the average earnings per year during the past 3 to 5 years?
What are the future projected earnings?
Are these Future projected earnings realistic?
How have these earrings been calculated?
Should the owner’s salary and perks, expenses, depreciation, taxes and interest be included or excluded in the calculation?
Do we include some of those one time expenses that appear on the books?
What Multiplier should be used?
What do we base the multiplier on?
Multipliers vary on the risk involved. But how do we measure that risk.
4.Tangible and intangible assets
Should the Real Estate, equipment, vehicles or inventory be included?
Is there a separate contract for the sellers consulting after the sale?
How about non-complete agreements?
What about other intangible assets for example, patents and franchises?
It’s been made quite obvious that determining an appropriate earnings multiplier can be somewhat subjective.In reality it is quite difficult to give a good estimate of a business’s market value as the small business market place of buyers and sellers is not easily observed. Buyers of small businesses tend to pay prices that are unique to their circumstances. Often way over or below what is considered to be fair market value.
As a buyer it is important to use common sense as well as remember that potential buyers create the market.
The six guidelines below can be used to better calculate earnings for a small business.
- Have hard look at the last 3 to 5 years earning on the seller’s tax return. Although you are looking into the past here, it is important to remember that you are buying the company’s future and not it’s past. These figures can be used to determine the projected annual future earnings with you at the helm. It’s important to ask yourself if you are experienced enough to run the business? Are you able to perform the duties and responsibilities of your predecessor?
- Examine both tangible and intangible assets. These assets are often found to have a value separate from the business. For example, having Real Estate and/or inventory available for resale is considered to be a lot less risky than having other assets of the business. This is due to the fact that real estate is more easily sold on the open market and the inventory can be easily liquidated should the business fail. Most of the time inventory is valued at cost. These assets may be valued separately and then added back to the multiple-derived value of the business. The other assets aside from real estate and inventory should be included in the multiple-derived business value as these assets will be needed to determine the projected future earnings.
- When there is real estate involved but not for sale the cost of rent needs to be subtracted from the earning figure. If the seller owned the business, he or she didn’t have to pay rent for the property but this would not always be the case if you are the new owner. However, if the seller was paying the mortgage equal to the rent that you will be paying this too is a consideration. Either way these expenses need to be taken into consideration.
- The owner’s salary, perks, as well as those one time payments also need to be included in the earnings calculation. If these expenses were found to subtracted from profit on the tax return you should add them back into your earning calculation.
- Depreciation/Amortization is a non cash expense. This means the owner does not have to pay out of pocket each year. If these expenses were deducted from the company’s profit on the tax returns, they should be added back to your earning calculation.
Earnings = Net Profit before taxes + Depreciation/Amortization + owner’s salary + Owner’s Perks.
- Usually, consultation from the owner during the transaction period and other intangible assets such as the owner’s agreement are included in the value of the company. Although such assets should be included at business closing for tax purposes.
Once the EBIT (Earnings Before Interest & Tax) has been properly calculated by accountants, consider the possible risks involved when owning the business. You need to consider how much you are willing to pay for the business taking these considered risks into account. For the minority of business, it’s around 3 to 5 times the EBIT. This multiple will be less when there are less tangible assets involved. But, more when the business is considered uniquely attractive.
In conclusion, the rule of thumb when doing a valuation of a small business is the earnings multiple. The right multiple often, depends on the view from the buyers stand point, simply coming down to assumed risk.
Most buyers tend to feel a lot better about buying a business with tangible assets they can feel and touch like real estate and equipment. However, buyers are also attracted to clearly obvious money making opportunities, with or without tangible assets.