Valuations

What is the best way to value my business if…?

Our clients who are selling a business have asked us many times, “What is the best way to value my business if…?” In response to that question, we’ve put together a quick and simple explanation of the most common terms and forms of valuation for businesses. We hope this gets you started and gives you an idea as to what pieces need to be put into place to get ready for the big day of selling your business. The day that you get the most money out of the business you’ve worked so hard building, or even if you’re buying a business, this will give you terrific value. Here are the most common points that we’ve assessed from clients questions about business valuations.

Gross Profit

Gross profit by definition is a company’s product or service revenues minus the cost of those goods (services) sold. As such, gross profit demonstrates the money remaining once the costs that a business pays to provide those goods or services, are accounted for.

Net Income/ Net Operating Income/ Profit

Net income is gross profit minus all other business expenses not included in the cost of goods sold. Net income is the money the business has at the end of a specified time period and is synonymous with profit. Net income is the foundation by which all of the subsequent formulas are calculated and is an integral part of any income based valuation method.

Earnings Before Interest and Taxes (EBIT)

This is net income plus all interest and taxes the company has paid. Many businesses are valued based on this number, however unlike EBITDA (Earnings Before Interest, Tax, Depreciation, & Amortization) it does not take into account depreciation and amortization. And so this does not adequately reflect the returns an all-cash-buyer would receive from the business.

Earnings Before Interest, Tax, Depreciation, & Amortization (EBITDA)

EBITDA can be a great way to understand the value of a Business. Both EBIT and EBITDA are typically used in manufacturing and wholesale businesses to determine value. Retail and service businesses typically rely more on cash flow and seller’s discretionary earnings. While EBITDA is a very popular method of valuing a business there seems to be an emerging shift away from it due to some of the following issues.

Problems with EBITDA

A key problem with using EBITDA is manipulated depreciation schedules due to the various methods of depreciation used in accounting. Because Depreciation may be added back differently by different companies it can create an artificially high value for a business, such as if they are using an accelerated depreciation method.

Another problem with EBITDA is that it rewards companies for debt while it detracts from the value of companies who are not borrowing. Unfortunately, growing a business is expensive and if attempted through debt, credit is given to EBITDA through amortization and interest expenses. If a company’s growth strategy is cash based, the EBITDA will be lower because there is no amortization or interest expense. Due to the way EBITDA values growth through debt, many companies, who may not want or can not receive financing, will choose not to grow so they can keep EBITDA high and therefore a higher value.

Cash Flow

Simply put, this is the amount of cash a business generates in a given time period. Cash flow is synonymous with seller’s discretionary earnings (SDE) for businesses with less than two million in sales. An exception to this rule is manufacturing businesses where differing forms of cash flow such as free cash flow will yield a value different from SDE.

Free Cash Flow

Free cash flow takes EBITDA and adjusts it to account for capital expenditures, working capital, and operating assets/liabilities. Without taking these expenses into account, EBITDA can appear to be higher and the value derived from this EBITDA would be artificially high. Many firms seem to be shifting towards this method of valuing a company. This method is not nearly as recognized as EBITDA and in many cases an explanation of the relationship between EBITDA and free cash flow should be required.

Seller’s Discretionary Earnings

Seller’s discretionary earnings (SDE) is EBITDA plus owner’s benefits & salary. As mentioned previously, in many businesses this is synonymous with cash flow however SDE does not always take into account the aspects that a free cash flow analysis would, such as working capital. SDE however does not penalize businesses for growing as EBITDA may. Whereas with EBITDA paying cash for a new piece of equipment would be detract from the business value, in SDE the business would receive credit for the purchase so long as it is not an annually recurring expense.

(Due to the complex nature of deriving these numbers it is best to consult an expert, such as a business broker. An expert will not only be able to help in the sale of a business but can also help increase the value of a business. It is important to note, that SDE, EBITDA, etc. alone does not make up the value of a business. An expert is also able to determine what multiple of these measures a business is likely to sell for in the marketplace.)

Conclusion

One of the best ways to start understanding the value of your business is to determine your “Owner Benefit Cash Flow”. The real amount earnings to the owner is important in a valuation. Sometimes an owner doesn’t take into account costs that affect his/her earnings. Complete a free Market Range Estimate to get a starting point on the value of your business.