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 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 metric, usually the seller’s discretionary earnings (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.
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 transactions for the specific industry, 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:
Review of the historical financial data from the recent years as well as the projections for the business
Select which expected cash flow metric to use and calculate that expected future cash flow
Select which multiplier to utilize for the valuation calculation
Multiply the expected cash flow by the market multiplier
Carlos, the business buyer, requests the relevant financial data, including recent tax returns, profit and loss statements, balance sheet, cash flow 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.
Carlos, with the help of his accountant, calculates the seller’s discretionary income (SDE) of the business as it has been shown to be the most reliable cash flow metric to use for small businesses, especially businesses that have less than $2,000,000 in top line sales. 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.
|Pro Forma||SDE Adjusted|
|Cost of Goods Sold||$300,000||$300,000|
|(Selling, General & Administrative)||$150,000||$75,000|
|Net Operating Income||$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.
With the calculated expected future cash flow 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:
|Expected Future Cash Flow||Multiplier|
|Estimate of Value||$550,000|
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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