MAINE BUSINESS BROKERS NETWORK
What's the Right Earnings Multiple?
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The easiest way to express this is using an earnings multiple. A business is said to be worth X times earnings. But, what is X? What earnings definition do we use? How do we narrow the range to a single number? How do we know it's right?
Luckily, there are some rough rules of thumb which most business brokers and appraisers seem to agree upon to begin to answer these diffucult questions. Let's review the two most widely used (and abused) estimates for earnings multiples.
Is it 1.5 to 2.5 or 3 to 5?
The most commonly heard earnings multiple range for small businesses is 1.5 to 2.5 times owner's cash flow. Another is 3 to 5 times earnings. While these appear to be different, they're really just two expressions of the same reality.
The key to understanding a business earnings multiple approach is to understand the earnings definition used. Different earnings multiples will result from different definitions of earnings.
If we use owners cash flow as our earnings definition, the earnings multiple will need to be lower because owners cash flow is larger than earnings before interest and taxes (EBIT). EBIT is calculated after a fair owner's salary is deducted, so I recommend using EBIT. But, if we use this definition, then, in most cases, the multiple is 3 to 5, depending on which of the two earnings definitions we employ.
Past or Future Earnings?
Another part of the second question, however, is whether to use some type of past earnings or future earnings.
My experience is that it is acceptable to buyers to use next year's projected earnings. This is supported in historical transaction data and is logical.
Many, if not most, will accept the idea that the current owner has laid the foundation for at least one year into the future. This validates using an earnings multiple of projected EBIT, as long as the buyer agrees that the projection is realistic.
Low End or High End?
Given the above ranges, then what's the right multiple within the range? How do we narrow the range? What makes the most sense?
The first time I read about a way to answer this question was in a landmark 1982 article in the Harvard Business Review. Today, many business appraisers are using this article's suggested technique.
The technique involves making an evaulation grid in categories we choose as being important for the business being valued. Non-financial characters such as a personal lifestyle choice, geographic location, or even a spouse's preference may be included.
Let's assume, for a moment, that we have concluded that we want to use the EBIT multiple range of 3 to 5 times earnings. But, we want to determine more precisely where the business might fall within the 3 to 5 range.
To make our determination, we might choose to rate the business using the categories in the accompanying table. In using this, I am suggesting a 0-3-6 rating scale for seven different categories. There is nothing fixed about these categories, though - the category choices are matters of judgment.
After rating the business in each category, we add up the result, divide by the number of categories, and we have a multiplier to apply to our estimated annual EBIT.
Test for Common Sense!
Because the result is a gross simplification, we must always test it for common sense. Can the business be purchased for our concluded amount under terms which are reasonable?
The suggested ranges of earnings multiples in this article came from solid sources of market data for small businesses. The national database for the Institute of Business Appraisers (IBA) suggests that 2.5 is the average multiple of owner's cash flow paid by small business buyers over many years and many categories.
This is the answer to our fourth question: How do we know it is right? We know because the ranges are confirmed by actual market data and the specifics by our own judgment. In addition to the massive IBA database, there are other sources in the business brokerage and appraisal world all showing about the same multiples.
Frequently Asked Questions
But, what about certain assets of the business like real estate, equipment, cash and inventory - are they included? What about expense adjustments for one-time expenses and owner's perks? What about depreciation and amortization expenses? What about the effects of special terms offered by a seller?
As to what's included in the multiple-derived value, the answer is basically everything required to make the business work. The equipment needed to run the business and a normal level of inventory are included. But, generally, the real estate and cash are not included. Real estate rent expense should be subtracted from earnings and the real estate value treated seperately. Working capital is also added and long-term debts (including the current portions) are subtracted.
Expense adjustments and owner's perks are dealt with in a variety of ways. But, by projecting EBIT one year into the future, much of this analysis of unusual expenses and perks can be side-stepped. Also, EBIT by definition gives you earnings after depreciation and amortization. If, however, depreciation and amortization expenses are excessive amounts above the level of real wear-and-tear on assets, I recommend replacing them with more realistic replacement reserves.
Finally, the terms sellers offer do make a big difference. If a seller finances the transaction on generous terms, the business is worth more to the buyer. At the multiples shown, seller financing is typically one-third of the price paid and is usually on pretty attractive terms. If the seller offers more than that, the price is higher.
In many ways, what we have reviewed here are general rules of thumb which, in the hands of a dishonest or ill-informed party, can be very dangerous. But, if used with knowledge, caution and common sense, their use can lead to a realistic estimate of what t business can sell for in the open market.
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>Business Buyers Matrix Rated<
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According to a Buyer Matrix developed by Canadian business broker David Hardy, an individual business buyer prospect is most likely to buy if he or she:
It is well known among business brokers that as many as 98 percent of all buyer prospects never actually buy a business. The best reason to hire a business broker is to focus the other 2 percent who have the cash, skills and ability to move forward.
Maine Business Brokers Network is a small business brokerage firm in Portland, Maine. Owner Glen Cooper has been a full-time general business broker and business appraiser since 1981. He handles small business sales, and mergers and acquisitions of larger firms up to $10 million in size in Maine and New Hampshire. The articles appearing here are from his quarterly newsletter, Maine Business Broker Network News. Cooper is a Certified Business Appraiser (CBA) with the National Institute of Business Appraisers and a Certified Commercial Investment Member with the National Assocation of Realtors.