Preface: You see [value] more creatively when you look at the world with other leaders who have different backgrounds and experiences. — Bill Taylor from The Best Leaders See Things That Others Don’t.
Business Valuation for Transition – Market Approach
A market approach to valuation is an analysis process that estimates a business value with a comparison of a business interest being analyzed to similar transactions of businesses that have sold on the marketplace with comparable company characteristics. The two primary methods of the market approach to valuation are guideline public companies and guideline transactions such as BIZCOMPS. BIZCOMPS is a detailed online database of private small company transactions. It is the most thorough and accurate resource for financial details on “Main Street” private small businesses.
With market comparisons, a valuation analyst can contrast similar small business transactions with a seller’s discretionary earnings or sales multiples. The seller’s discretionary earnings are a business income before taxes, non-cash expenses such as depreciation, non-operating expenses such as loan interest, and extraordinary expenses and owner’s salaries. The seller’s discretionary earnings differ from EBITDA in that it also adds back the owner’s salaries and certain discretionary expenses on the profit and loss statement.
To estimate a business value with seller discretionary income, a valuation analyst must first calculate the obtain an accurate seller discretionary income amount. Once having completed that math, the analyst then analyzes the valuation metrics from a guideline market comparison to find the best comparable for a business valuation estimate.
The sellers’ discretionary earnings are then multiplied by the corresponding multiple or average multiple for an estimate of value. For example, a business with seller discretionary earnings of $400,000 including net profits of $125,000, depreciation expense of $175,000, owner’s salary of $75,000, and interest of $25,000 may have a multiple of Seller discretionary earnings of 2.5. The value estimate would therefore be one million dollars in that example. Multiples for sellers’ discretionary earnings vary from both industries and businesses. The market approach is often a guide for valuation reasonableness when using an asset or income approach to valuation.
A multiple-of-sales approach is more straightforward with a calculation of a business value based solely on top-line sales revenues. For example, a transaction database may show a business value ranging from .40 to .55 of topline sales. So a valuation analyst would look first at the range of sale multiples represented for the industry and then select the most alike transactions to zoom in and calculate a value estimate.
A business with sales of $2,500,000 with a .42 sales multiple would be worth an estimated $1,050,000 from a marketplace approach estimate for instance. Market approaches are facilitated with standard valuation libraries. Any business valuation that does not include at least consideration of market transactions is increasingly subject to analysts’ bias and opinion and therefore more subject to error. An example is a rule of thumb calculation that a business is worth a certain multiple of sales.
Each business is unique, and a proper estimate of business value will incorporate and consider the uniqueness of a business in a value estimate. For instance, if someone gives a valuator a businesses topline sales and net profits a marketplace analyst an estimate may be possible, but market approaches don’t provide all key characteristics such as key customers, location, networks, and other competitive edge approaches that are safeguards to premiums or discounts on valuation estimates.
A valuation analyst also makes a prophecy of sorts about the future value of the future cash flows of a business when preparing an estimate of value whether a calculation of value or a conclusion of value. Again, no two businesses are identical. Therefore, while using market approaches as a quantitative process as a check of reasonableness with a small business transaction is highly advised, more importantly, is the qualitative and cumulative sage expertise, knowledge, and experience of the valuation analyst preparing the valuation estimate.
….to be continued….