Understanding what your business is worth can be a critical issue in several circumstances. They can run the gamut from divorce, partnership dissolution, estate issues, buy/sell agreements, ESOPs, or, most commonly, the sale of the business to a third party or key employee. The ultimate determination requires a business valuation.
Regardless of your reasons, you’ll come up against some common methods when having your business valued, including asset-, income-, and market-based approaches. “We rarely weigh the asset approach in our overall value, with the exception of businesses with a high concentration of assets and no intangible value coming from the company’s earnings,” notes Gary Rayberg, president of ROI Corporation, a Weymouth-based business brokerage and business valuation firm.
The income approach
Two of the most prevalent methods in the income approach include capitalization of earnings and discounted future earnings.
- The capitalization of earnings method involves selecting the appropriate economic earnings stream to capitalize—such as the company’s earnings before interest, federal income tax, depreciation and amortization (EBITDA)—and then taking the economic income and dividing it by the appropriate capitalization rate. “The appropriate economic earnings stream could be the last full year, an average of several years, or a weighted average of several years,” Rayberg explains. “The economic earnings are then capitalized by the appropriate capitalization rate. Lastly, adjustments are made to convert the pre-tax earnings to net income to eliminate the tax effect, and a long-term sustainable growth rate adjustment is made.” This method closely aligns a multiple of earnings, as the capitalization rate is the inverse of a multiple of earnings. For example, a 20 percent capitalization rate is a five multiple (five times 20 percent=100 percent) and a four multiple is a 25 percent cap rate.
- The discounted future earnings method appears to be completely different from the capitalization of earnings method; however, if all of the assumptions are identical with respect to the economic income, growth rates, income tax rates, etc., it will yield similar results, notes Rayberg. If the expected economic income is a level amount with a constant growth rate, the discount rate would be equal to the capitalization rate. The discounted future earnings uses a finite period of projected earnings, such as three, five, or 10 years, coupled with a long-term growth rate into perpetuity. Future earnings are then discounted to a present value based on the discount rate. “In a perfect world the discounted future earnings method is considered the most appropriate method to use in appraising a business,” Rayberg says. “However, we’ve found that overly aggressive projections and growth rates can produce inflated values.”
The market approach
The market approach compares the subject company with sales of similar businesses to estimate a relative value. Two common market approach methods are market value of invested capital to revenue and market value of invested capital to normalized EBITDA. “Earnings multiples tend to be more relevant that revenue multiples,” Rayberg says. “We’ve found that buyers and sellers both want know what market comps show. That said, the market approach is only as good as the data used and the comps analyzed.”
Because business value can change depending on market and other factors, it makes sense to get a fairly consistent handle on the worth of yours, as you never know when it might come into play. “For example, one of our clients—Cambridge Sound Management—had grown beyond the comfort of one of its partners, and needed to engineer a buyout,” says Patrick Padden, senior vice president, Corporate Banking, at Salem Five. “Because they had a history of regular, third-party valuations, there was little, if any, discussion among the parties as to the value of the piece of the company being acquired by the other owner.”
In getting a business valuation, Padden recommends securing the services of a professional third-party valuation firm. “It’s also important for a business owner to try as much as possible to keep the emotion out of any consideration of value,” he adds. “Often, the owners have either started the company from nothing, or have grown it from something very modest. It can be hard to come to grips with the realities of an objective, third-party mathematical equation that places a value on something that has consumed significant time, sweat, angst, and other emotional investments over a period of time, but it should be a truly objective measure.”