One of the most asked questions I get is in regard to valuation. I try to keep the topics in this newsletter varied and cover diverse topics relative to buying or selling a business, but given the interest in this topic, here is another on valuation, specifically valuation multiples.
The most common valuation multiples are Earnings multiples and Gross Sales multiples. For example, say a business has $45,000 in earnings and a multiple of 3, then the indicated value would be $135,000. Or alternatively, sales of $200,000 and a multiple of .85. Then the indicated value would be $170,000. There-in lies the secret as to why they are used. They are simple to use and understand. Bankers, Brokers, Accountants, Educators and other advisors often use them. I occasionally use them, but I’m not a big fan of this approach. Here is why:
The multiples vary depending on the industry. The standard multiple quoted is often between 2.6 and 2.8. However, they are often broken down per industry classification. Here is an example: an air conditioning contracting business might be at 1.5 times earnings and an accounting practice up to 5 times earnings. So as you can see, adjust a few details and this simple multiplier approach starts losing its reliability.
What are earnings? There is a lot of confusion about this and it’s applied differently by practitioners, often unintentionally. Are earnings the net profit on the tax return? Are they before or after taxes? Do they include the owner’s compensation or is that after that’s deducted as an expense? What about other expenses like loan payments, depreciation, Amortization, or stated rent? Given the results do you add inventory to the valuation? Did the valuation include the real estate?
Questionable Data. Where do these multiples come from anyway? Unlike real estate where the sale price is public information, the sale price of a business is not. In fact unless it’s publicly traded in the stock exchange, the sale price of a business is confidential. Often it’s a condition of the sale that the parties not disclose the sale price. So as they say in the computer data entry field, garbage in garbage out. The reliability of this data must be questioned.
Text Book vs. In the Field. What the ‘books’ say is great. But how does that relate to what is happening in the field? Even if the book is right, why? These are questions that troubled me. So I thought I’d put it to the test. I wanted to take this information and write an article to discredit this approach. I had my Office Manager go pull all the closed business sales for the last few years. I had her take each file and divide the sale price by the stated earnings to see what it came up with in our market (see chart below).
The results were interesting. First to my surprise, it did, on average, support the standard earnings multiplier. The key words are on average. However, that represented the fact that half were more and half were less than the multiple. Stated another way, if we priced a business based on those numbers solely, half of our sellers would have received less than what they should have for a business they had poured the heart and soul into. The other half would be in denial and wondering why their business didn’t sell, and in some cases may have gone out of business instead of receiving a fair market value.
So, although applying multiplies is simple, if you want to know the value of your business perhaps you should ask someone in the field and have them do a more thorough valuation for you.