Valuation Rules of Thumb

2misi.com

If we are going to use a rule of thumb to value a business, some type of earnings multiplier makes the most sense to prospective buyers. It directly addresses the buyer's motive to make money - to achieve a return on investment.

Two areas of confusion are inappropriate comparisons to investment real estate and/or to stock market earnings multiples. Real estate is often priced at 8 to 10 times its net operating income. Stock market prices are often as much as, or even more than, 20 times earnings.

These two comparisons do not work for small businesses primarily because the risk of owning a small closely held, privately owned business is thought to be much higher than owning either real estate or publicly held stock. Running a small business is also a lot tougher than managing an office building or a stock portfolio.

But, even if we settle on an earnings multiplier, we are not even able to start the valuation process until we decide which earnings figure we are going to multiply. Is it last year's earnings? This year's? Next year's? Is it the last five year's earnings averaged? Is it the next five year's projected?

The next issue is our precise calculation of 'earnings.' Should it include or exclude the owner's pay and perks, interest expenses, depreciation and taxes? What about those one time expenses that may be on the books?

But, What's the Right Earnings Multiplier?

After we define which 'earnings' we should use, we still have to choose the right multiplier. How many times are we going to multiply earnings to get to a value of the business? Is it 1, 3, 5, 8, 10 or 20? Based upon what? Figured how? Most people can agree that this multiplier will vary based upon the risk of the business, but how can that be measured?

What about the various tangible and intangible asset values? Do we include the real estate, equipment, vehicles, inventory? Is there a separate value for a seller's agreement to consult with the new owner after the sale? What about non compete agreements? What about patents, franchises and other extraordinary intangibles? 

http://www.2misi.com/article/2012/06/valuation-rules-of-thumb