Market / Comparables Approach
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- Market / Comparables Approach
Comparables/ Rule of Thumb Business Valuation
The rule of thumb business valuation approach values the subject business based off of the selling price data from recently sold similar businesses. The concept of valuing a business in this manner is similar to how homes are valued in the real estate market. Typically, homes are valued relative to recently sold homes in the area, with the recently sold homes’ data adjusted to be more comparable to the subject home to be sold. By applying this same principle to the business valuation market, the goal is to calculate a business valuation that reflects the fair market value, or the “going rate,” in the market within which the business is operating.
A key consideration here is to utilize aggregated comparables data, adjusted for an apples-to-apples comparison. If data from only a few specific recent transactions in the market are used as a comparison, then it is quite likely that other, unknown factors that are impossible to verify, specific to those deals, might have heavily impacted the sales The total amount in dollars made in the business before expenses are deducted. See also Gross Revenue. price. That is the reason why a large, accurate database is necessary for the market method of business valuation.
The subject business’s financial data is also very relevant for this business valuation method. It is key to find an accurate cash flow The net profit before taxes plus payments to the owner(s), interest, and depreciation of assets. metric, usually the seller’s discretionary earnings Total earnings received by a business based on the U.S. Income Tax Return. The financial numbers of these earnings depend on the type of… (SDE) for small businesses with less than $2,000,000 in sales, to multiply by the comparables multiplier. After all, it will be counterproductive for a business buyer to calculate an inaccurate valuation by making an error on the primary input variable (near-term expected cash flow).
How is it calculated: Choose the appropriate expected future cash flow then multiply that figure by the appropriate multiplier
When to use it: if the subject business is generic and the market has a large amount of accurate comparables data available to use. Additionally, it helps to answer the question of ‘does this make sense?’ if there is a different valuation or price to compare it to.
Pros
- Utilizes actual data based on actual historical transaction prices
- Relatively simple to calculate
- Assuming good data, it can give the business buyer an overall accurate figure for how similar businesses are being valued
- Experienced valuators typically understand the issues with comparables data and can therefore adjust to accommodate for them
Cons
- Very reliant on accurate, quality comparables data in order to figure out the most accurate and appropriate multiplier to use
- Every small business is different, with many affected by local competition. The multiplier can be too broad to use given the specific characteristics of a given business for sale
- There is no data on the 75% of small businesses that did not sell, thereby skewing the comparables data which is based only on sold businesses
- Need to ensure that you are comparing “apples to apples” by using the same definitions of cash flow (either seller’s discretionary earnings, EBITDA, net income, etc.) as the comparables which are being used
Illustrative Example Business Case for Calculating Business Valuation Using the Rule of Thumb Approach
Example Business – Sarah’s Auto Repair Service Center
Now we can look at a simple example of how the market/comparables approach to business valuation can be used. Sarah is the business owner of an auto repair service center. The business has been open and operating for the past 10 years. It is performing well, with modest profitability and growth prospects. However, Sarah has decided that she would like to sell the business and retire.
A potential business buyer named Carlos has found the listing for Sarah’s business and would like to calculate a fair valuation for the business. As auto repair service centers are quite a common business, and Carlos/his business broker have access to recent small business sales The total amount in dollars made in the business before expenses are deducted. See also Gross Revenue. transactions for the specific industry A particular form or branch of economic or commercial activity. Subindustries are often referred to as categories on Vettedbiz.com, they decide to calculate the valuation using the market/comparables method.
In order to calculate the valuation using this methodology, they will follow the below steps:
Step 1
Review of the historical financial data from the recent years as well as the projections for the business
Step 2
Select which expected cash flow The net profit before taxes plus payments to the owner(s), interest, and depreciation of assets. metric to use and calculate that expected future cash flow
Step 3
Select which multiplier to utilize for the valuation calculation
Step 3
Multiply the expected cash flow The net profit before taxes plus payments to the owner(s), interest, and depreciation of assets. by the market multiplier
Calculating the Valuation
Step 1 (data collection)
Carlos, the business buyer, requests the relevant financial data, including recent tax returns, profit and loss statements, balance sheet One of the major financial statements for a business that reports a company’s assets, liabilities, and stockholders’ equity typically in that order. Assets and…, cash flow The net profit before taxes plus payments to the owner(s), interest, and depreciation of assets. statement, and projections of the business, in order to gain a better understanding of the business. Accurate data is incredibly important when calculating the expected cash flow of the business as the expected cash flow will be used to calculate the valuation of the business.
Step 2 (cash flow calculation)
Carlos, with the help of his accountant, calculates the seller’s discretionary income Income, also known as earnings or profits, is money that a person or a business receives in return for working, providing a product or… (SDE) of the business as it has been shown to be the most reliable cash flow The net profit before taxes plus payments to the owner(s), interest, and depreciation of assets. metric to use for small businesses, especially businesses that have less than $2,000,000 in top line sales The total amount in dollars made in the business before expenses are deducted. See also Gross Revenue.. In order to do this calculation, adjustments to the near-term projected profit and loss statement must be made. These adjustments include removing non-operating or non-recurring expenses from the business. Examples of these expenses include Sarah’s personal vehicle costs which are on the company’s profit and loss statement as expenses. Once the SDE is calculated, Carlos can move onto step three.
Projected Income Statement
| Pro Forma | SDE Adjusted | |
|---|---|---|
| Revenue | $1,000,000 | $1,000,000 |
| Cost of Goods Sold Also known as Cost of Sales, Cost of Goods Sold includes the direct costs associated with generating revenue. Depending on the business, it can… | $300,000 | $300,000 |
| Gross Profit The profit a business makes after deducting the costs involved in making, providing, and selling the goods and services. In an income statement, it… | $700,000 | $700,000 |
| Labor | $250,000 | $250,000 |
| Rent | $100,000 | $100,000 |
| (Selling, General & Administrative) | $150,000 | $75,000 |
| Net Operating Income Operating Income = Revenue*- COGS or cost of revenue−Operating Expenses or Operating Income=Gross Income−Operating Expenses Also known as Income from operations, income before interest… | $200,000 | $275,000 |
Note that in this example, an adjustment was made to decrease the SG&A (selling, general & administrative) expenses of the business as it was found that the business seller was running a number of non-business related expenses through the business, including this personal vehicle, vacation travel expenses, and the family cellphone bill.
Step 3 (selection of market multiplier)
- Trend of cash flows including revenues and measures of profitability
- Management structure and size of company
- Concentrations or unusual risks or reduction of risk
- Clarity of comparables
- Any known local market comparables (reported or not)
- Comparability of subject company to comparables
- Profitability charting and comparison to subject
- Timing of economic cycle
- Industry A particular form or branch of economic or commercial activity. Subindustries are often referred to as categories on Vettedbiz.com trends
- Any material factor not included above
Multiplier
2.0
Step 4 (calculation of valuation)
With the calculated expected future cash flow The net profit before taxes plus payments to the owner(s), interest, and depreciation of assets. and comparables multiplier in hand, Carlos can now calculate the value of Sarah’s Auto Repair Shop using the market/comparables method. Below is the calculation:
Calculation of valuation
| Expected Future Cash Flow The net profit before taxes plus payments to the owner(s), interest, and depreciation of assets. | Multiplier |
|---|---|
| $275,000 | 2.0 |
| Estimate of Value | $550,000 |
Summary
With the steps completed, Carlos can now negotiate the price of the business confident that he has a valuation that makes sense for the type of business he is looking to acquire. The end price of the business will very likely be different from the valuation that has been calculated due to a variety of factors. However, it is important to have a calculated valuation in mind during the negotiation in order to avoid overpaying for a business that will not provide the requisite investment return to make the investment worthwhile.
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