Business Valuations

Many firms offer “business valuations”. A certified valuation report is written by a credentialed professional based one of three methods: Income Approach, Market Approach or Asset Approach.

Income Approach

This is based on the premise that the value of any asset is the present value of future cash flows. An appraiser will assess historical cash flows (capitalization of earnings) or create projections (discounted cash flows) to value the business. The cash flow is then discounted  or capitalized according to the risk free rate of return and various risk premiums including company-specific business risk. The income approach is a function of earnings and risk. Risk can be broadly thought of as the risk of the likelihood the earnings will continue in the future.

Market Approach

This is based on the premise that the value of an asset is determined by the price of similar assets in the market. The appraiser will determine the appropriate cash flow and apply various multiples. Common multiples for small business owners are revenue, EBITDA and SDE. EBITDA is an acronym for earnings before interest, taxes, depreciation and amortization. This is a common measure of true cash flow. SDE is an acronym for seller’s discretionary earnings. This takes cash flow one step further. It adds in compensation for a single owner plus any personal expenses. EBITDA is used more often with larger businesses with less direct owner involvement and there’s a fully functioning management team.

Asset Approach

This is determined by calculating the market value of the assets of the business. This method is typically only applied in a liquidation scenario. The value is solely based on the market value of the tangible assets of the business.

Business brokers typically rely on the market approach when determining a list price for a business. Brokers will typically calculate and average SDE’s for 3 years and multiple it by 3. More aggressive brokers will apply the multiple from the best year. Revenue at 40-60% of annual sales and EBITDA at 3-5x and SDE at 2-3.5x – Most main street and middle market businesses will fall into these ranges.