Valuation
The way to evaluate the price of a business can be ascertained by using certain rules of thumb. Rules of Thumb, despite all caveats about using them in pricing businesses, they are commonly used to do just that. The answer why is quite simple—the rules are very easy to use. But how accurate are they? A lot more than people think. They may supply a quick fix, but if used properly, rules of thumb can come pretty close to what the business will ultimately sell for.
Most rules of thumb are market-driven; that is, they are a result of actual sales. This means they come closer to being a sale price than an asking price. Many of the rules of thumb come from industry consensus that can be found in reference books on valuation like “Business Reference Guide” or various valuation websites like
www.bizcomps.com
Rules of Thumb usually come in two formats. The most commonly used rule of thumb is simply a percentage of the annual sales, or better yet, the last 12 months of sales. For example, if the total of sales were $100,000 for last year, and the multiple for the particular business is 40 percent of annual sales, then the price based on the rule of thumb would be $40,000.
The second rule of thumb commonly used is a multiple of earnings. In small businesses the multiple is used against what is termed Sellers Discretionary Earnings (SDE). It is usually based on a multiple (generally between 0 and 4) and this number is then used as a multiple against earnings of the business.
For example, most business buyers are looking to make back their investment in 2 to 3 years for the average business, so if the net or SDE for the business is $100,000 and the rule of thumb is say 2.5 of SDE then the business can be conservatively priced at $250,000 not including Inventory or Furniture, Fixtures & Equipment.
Other terms used to express earnings are as follows, along with a definition of SDE
EBDIT (EBITDA) - Earnings before depreciation (and other non cash charges), interest and taxes.
EBDT - Earnings before depreciation (and other non-cash charges), and taxes
EBIT - Earnings before interest and taxes.
Sellers Discretionary Earnings – The earnings of a business prior to the following items.
Income taxes
Non-recurring income and expenses
Non-operating income and expenses
Depreciation and amortization
Interest expense or income
Owners total compensation for one owner/operator after adjusting the total compensation of al owners to market value
Keep in mind that the multiples for the different earnings acronyms will be different than the multiple of SDE, which, as mentioned, generally is a number between 0 and 4. The rules are very specific about what is being used. It can be 2 times SDE or 4 times EBIT, etc.
Please note the price determined by the rule of thumb, does not include inventory, real estate, and the other balance sheet items such as cash and accounts receivable. The price derived from the rule of thumb is for the operating assets of the business plus intangible assets (goodwill) of the business. It also is assumed that the business will be delivered free and clear of any short and long-term debt. If any debt is to be assumed by purchaser, it is subtracted from the price based on the rule of thumb method.
Besides the rules of thumb these contributing determinants can be used indiscriminately by owners and buyers to establish the approximate valuation of a business.
Amount of Competition
Amount of Risk
Historical Profit Trend
Location & Facilities
Marketability
Industry Trend
Ease of Replication.
Also, Inventory, Furniture Fixtures and Equipment, the length of the lease and if property is included, can effect much of the interpretation of the value of the business for sale.
In the event that formulas and acronyms are not effective enough of a method, a business owner can contact peer owners in the area or industry and find out what they think of valuation levels for businesses like the one the owner has. Vendors, distributors or equipment manufacturers can also be of help in the valuation of a business. Trade associations for a particular industry are great places to find an expert who can give you some sound advice on the valuation of businesses in that industry.
In conclusion, valuation is not a science, but can be a formula, it would be wise then for any business owner looking to find out the value of their business to be prepared to be open minded and thick skinned when it comes to the final price evaluated by others. But business owners should not be disheartened, as in the end it will be their personal estimation and the market that will determine the selling price of their business. The valuation process then is a necessary step to cover bases, but it is not the final word on pricing, that will always be left to the owner.