Behind a Business Valuation, Part I

Tom Crouser May 28, 2013 Comments Off on Behind a Business Valuation, Part I

By Tom Crouser

What is a business worth? A business valuation is a good start but too often that’s all we focus upon. There are lots of issues surrounding a business sale including issues with the price itself up to and including what the seller will do afterwards. Let’s first look at the selling price of the business.

ValueSmallestThere are numerous methods of valuation but regardless of what printers agree upon, it doesn’t mean spit because it’s what bankers and investors believe that counts. Therefore both buyers and sellers should know what’s behind the standard valuation methods.

For example, EBITDA (a multiple of Earnings Before Interest, Taxes, Depreciation and Amortization and pronounced e-bud-dah) is one which measures operating cash flow multiplied by a number of years. It’s like the buyer says, “I’ll pay you the last three years’ of earnings for your business,” (typically 1.5 to 3.5 years).

Why eliminate Interest, Taxes, Depreciation and Amortization? In comparing two companies, one may have little debt and low interest expense while the other has a lot of interest expense. Yet, the company with high interest expenses can be earning MORE if interest wasn’t considered. After all, it’s not the businesses’ fault the owner had to borrow money to buy the business.

Same is true with Depreciation and Amortization. One company takes Section 179 accelerated depreciation and the other doesn’t. One shows Goodwill expense and the other doesn’t. And taxes? C corporations pay federal and state income taxes while S corporations don’t.

The deal is even more attractive if the buyer feels they can increase the EBITDA but no, they’re not going to pay you for what they have to do.

The downside of EBITDA (e-bud-duh) is that it treats owner’s salaries as management salaries where, in truth, some of us take higher salaries and lesser distributions (dividends) while others take a lower salary and higher distributions. Unless modified to treat owner’s compensation as earnings instead of an expense, you could be undervaluing the business.

Another method is capitalization of earnings. That’s where earnings are treated as interest from a bank account. For instance, $100,000 of earnings would be generated from an account of $2 million earning 5% annually. “Whow, my business is worth $2 million! “ Not so fast, Sherlock.

Which would you rather have; $2 million in the bank or a printing company? Say money in the bank. Why? That’s more secure. And that’s why this business value is heavily discounted. How much? I’d expect $100k of earnings to fetch $250k in a sale, so that’s a discount of 87.5% off of the $2 million capitalization of earnings value. Told you it was heavily discounted.

Why? Unlike owning stock in General Motors, you are actively involved as it’s not a passive investment. Also it’s harder to lose money in a bank account than in a business.

Capitalization of earnings is one way to measure the value of a business. Like all methods, you have to know what the numbers mean otherwise you will get a false sense of value.

What about percentage of sales? There isn’t such a thing. Oh, you can take the selling price of shops and divide by their sales and get a percentage but this isn’t a way to VALUE a business. It’s simply a coincidence.

A $500,000 sales shop earns $100,000 (20%) and sells for $300,000 can give you the false impression that shops sell for 60% of sales. Nothing is further from the truth. Same shop earnings $20,000 would be valued as parts.

On the other hand, it can be a rule of thumb. If you are offered a $500,000 shop for $1 million; pass.

There are more methods. Using a number of them, an evaluator develops a range and then specifies a price within the range. Also note that these methods apply to businesses earning more than $100,000. If a business is earning less than that, then other asset based methods are used that can be related to selling a car for “parts.”

Those are some of the issues you should know regarding the business evaluator’s “price.” Next, we’ll cover other issues, some of which are not under your control.

Other articles in this 2 part series

Part I, Behind a Business Valuation Click Here

Part II, Behind a Business Valuation Click Here

Or search on “valuation” in our website’s search engine.

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