Business Value Methods in Plain Language

Thousands of books and courses have been developed to explain and teach how to value a business. This website will not attempt to cover everything. The below descriptions are very brief. For each of the methods, there are many thousands of pages of text explaining the concepts and methods that are used in determining the value of a business using this method.

Examples are a CAP rate of 10 means the income will pay for the investment in 10 years. If a CAP rate of 33.33 is used, the period of time is 3 years. If a CAP rate of 20 is used, the recovery period is 5 years, 25 is 4 years. The CAP rate is a judgment chosen by the purchaser to determine how fast they want to recover their investment.

2. Multiple of Excess Earnings is a method required by the Internal Revenue Service to meet the requirements for valuing a business. It is a more complex valuation method than some of the other methods. Tangible, working capital, and other non-intangible assets are used to determine that if they were converted to a save investment what would they return in income. Generally, the safe investment is US Treasury Notes or Bonds. The safe investment rate of return could also be 3-5-10 year government-guaranteed Certificates of Deposit at Federally Insured Banks up to the guarantee limit. The method then takes that safe investment income from the income of the business. This income is Earnings Before Interest Taxes Depreciation and Amortization (EBITDA), but after a buyer has received market compensation for their work in the business. The difference between the business EBITDA and the safe return on assets is the above asset value of the business or the goodwill.

Next, this number is multiplied by the Risk Price Multiple (RPM). The RPM evaluates the different components of Finance, Control, Marketing, Sales, Production, Service and Intellectual Capital. These are generally ranked from 1 to 5 with 1 being the lowest value and 5 the highest. Some will say that 5 is too low and 1 is too high. These can be detailed quantified, but ultimately it is still a judgment of the quality of these different factors for a particular business. In plain language terms a rate of 1 means the business will be able to maintain its earnings at that level for 1 year. A rate of 5 means it will be able to maintain that rate for 5 years. This is normally considered the value of Goodwill – or the various components of Goodwill. Next, this amount is added to the value of the assets used to calculate the safe rate of return.

The resulting combination of the two factors represents the total value of the business.

3. Levering (or Leveraging) Cash Flow-Seller Financing calculates how much debt the business will be able to repay from the cash flow of the business based on assumptions for interest rate and term of the loan from the seller. A key consideration in this method is the “Earnings Set-Aside”. This is the amount of money not available for making the payments on the purchase loan that is reserved – or – set-aside to fund future growth in accounts receivable, inventory other working capital and to some extent other assets purchased for growth. Frequently we use a rate of 25 percent or one-fourth of cash flow will be needed to provide for growth. For some businesses this is too high and others maybe too low. The difference is the rate of growth and how long it takes to achieve the growth in the business. After, you know how much is going to be available to make the payments on the purchase of the business loan, the interest rate and the duration of the loan, a value can be calculated. This is a loan amortization schedule that calculates these amounts. This is one number for the value. The next value is the earnings set-aside using a Capitalization Rate. This CAP rate may be the same rate as used in the Capitalization of Income method. Or it may be higher or lower depending on the investment criteria of the buyer. These two amounts are then added together to come up with the value based on the seller providing financing with specific terms and the earnings growth retained in the business.

4. Levering (or Leveraging) Cash Flow-Bank Financing which is very similar to the Seller Financing method with some different conditions/assumptions. Both have the “Earnings Set-Aside” but the Bank Financing method also includes bank term called the “Debt Coverage Ratio”. In uncomplicated terms, it is a cushion. The debt coverage ratio is how much can the business earnings go down and still be able to make the loan payments. In this situation, the Small Business Administration (SBA) has determined that a 25% cushion is needed. However, from experience, normally the bank lender will bump this up to 40%. This is mechanically done, by the lender determining that various items in the income statement may not be sustainable, and reduce certain revenue items or increase certain expense items. With these adjusted items the lender then has the 25% ratio but in reality, is closer to 40%, if the income statements are accurate. As in the seller financing calculations, we determine the amount of the ‘Earnings Set-Aside”, which is an amount needed for cash for future growth of the business. Then we reduce the cash flow available for making debt payments by the “debt coverage ratio” which is the SBA or lenders cushion for unknowns. In calculating the value of the business this debt coverage amount, will accumulate over the years of the bank loan. This will be added to the value of the business. The CAP rate used on the “Debt Coverage Ration” (which is for only 1 year) is then projected out to the future to determine its value. The Capitalization (CAP) rate is then used to accumulated the value of this amount of money growing into the future. Conservatively, we use the same rate as was used in the other areas where a CAP rate was used. However, some say this should be the term of the loan. So, again this is a judgement factor. Ultimately, the method adds 1 – the earnings set-aside 2 – the debt payable by the business plus -3 the debt coverage ratio capitalized to calculate the value of the business.

5. Multiples Based on Seller’s Discretionary Earning is a market-based method. This is ratio is based on sales of comparable businesses. Generally, this is based on the NAICS code for that business. The calculation is based on Sellers Discretionary Earnings (SDE) or Owners Discretionary Earning (ODE) or Owners Discretionary Cash Flow (ODCF) times a multiple that similar business have sold for in a certain date range.

6. Comparables based on EBITDA. This is also a market-based method. There are several private or subscription data bases that contain key information on sales of small businesses. These are generally business with as low as $50K in annual revenue to up to around $15M in annual revenue. Access to any of these is limited to paid subscriptions. Information is grouped by NAICS codes, date of sale, annual revenue, EBITDA, SDE, fixed assets, inventory and sometimes location.

7. Comparables based on Revenue: This is also a market-based method. There are several private or subscription data bases that contain key information on sales of small businesses. These are generally business with as low as $50K in annual revenue to up to around $15M in annual revenue. Access to any of these is limited to paid subscriptions. Information is grouped by NAICS codes, date of sale, annual revenue, EBITDA, SDE, fixed assets, inventory and sometimes location.

8. Net Present Value of Sustainable Free Cash Flow is one of the most complex methods used to value a business. It requires a projection into the future of what the cash flow will be for a particular business going into the future 5 to 10 years. This is because smaller businesses generally have unstable or less predictable sales and earnings. The method starts with projected future EBITDA and subtracts from EBITDA estimated capital expenditures that will be required to maintain growth. This method is generally used for larger businesses mainly those over $50,000,000 a year in revenue. The formulas that drive this method are very complex have many different components and require a high level of training. Even with Jim Eaton’s 35 years as a CPA and having completed many courses on business valuation this can be difficult. A simplistic thought concerning this is to realize the business has to pay for itself through earnings in the future.

If you think of an amortization schedule on a loan, this is part of the concept. Because these earnings are in the future there are interest rates and risk factors that must be considered in determining the value of the business. The standard concept of EBITA was developed in the 1950’s and 1960’s. For methods based on earnings, it still is the basic starting point. However, today a term called Sustainable Free Cash Flow which modifies the concept has gained significant importance. Although the concept is here, it is somewhat subjective and accordingly is not totally endorsed by all as a better base number to use in valuing a business. The concept of Sustainable Free Cash Flow means that for a business to pay for itself over future periods an amount must be subtracted from earnings for equipment replacements and other depreciation equivalents. An example of this would be a car rental company that never made any profits. Without the sustainable free cash flow concept, where new rental cars purchased are considered an expense or at least economic depreciation of the vehicle fleet it would appear to be an extremely profitable business. Because the amount of sustainable free cash flow can be subject to interpretation, EBITDA is often used. The EBITDA method without modification can result in a value that will not be achieved. For businesses under $2,000,000 in revenue, we have not seen this method used in an actual purchase or sale transactions.

9. Liquidation value comes into use when either a company is in a loss position or has been unable to maintain profitable operations for a period of time. The liquidation value is what could be obtained over a reasonable period of time from selling the assets in an organized fashion. This is not a one-day auction of everything. It is an orderly liquidation. Depending on the type of assets it may take years to complete a total liquidation. A forced sale will result in a much lower value.

10. Adjusted Book Value starts with the net book value also known as owner’s equity, shareholders’ equity, or partners’ capital or equity. As a beginning point, the financial statements should be in accordance with Generally Accepted Accounting Principles (GAAP). Then the values of various assets and liabilities are adjusted to fair market value for each of the items. An example would be, if there was a building that had been substantially depreciated and in the market place it had appreciated in value. This would be increased to the current fair market value. Similarly, physical property, patents and other assets would be evaluated to determine the fair market value for each of the assets. There may be other adjustments needed for off balance sheet leases that in essence are above or below market value.

11. Public Company Guideline Methods use stock market information to compare publicly traded companies based on total capitalization, earnings per share and much more information. Because small and mid-sized businesses are not publicly traded the information is not available and does not really compare to these larger companies.

12. Analysis of Prior Sales of Stock Although small businesses do not normally have many sales of stock of the company, it does occur. Additionally, buy-sell agreements are more common with small businesses today. The formulas and methods in these agreements may be a starting point for the value of the business. If the agreements have values that are binding and have been recently updated there is a strong indication of the value of this business. In litigation, the formulas in the buy-sell agreements are often looked at by the courts as a method of valuing the business.

13. Rules of Thumb – The textbooks and most valuation specialists will advise you that they are not valid and should not be used. I agree most of the time. However, they may be useful as a figure for a reality check. Many small businesses, that is those under $500,000.00 in revenue will often sell based on these rules of thumb. For instance, small CPA firms will sell for .75to 50times annual revenue. Small insurance agencies will often sell for 1 to 2 times annual renewable commissions. Generally speaking, the businesses with the lower profits will be in the low ratio and the businesses with the highest profits will be in the highest range. These are just a few examples there are many more. We have a chart of some of the rules of thumb that I have compiled from various sources and actual transactions.