Calculation Methods for a Business Valuation

When a client comes to us seeking a valuation of their business, sometimes the unbiased opinion we deliver is not what the client expected. Often, it’s a result of the client using a general or oversimplified multiple or ratio of some earnings measure to calculate an estimate. Here’s one recent example:

“John” was getting ready to sell his fabrication business. A few of his friends and business brokers provided him with market data that helped him get a rough value estimate. The data had included ratios and multiples of certain financial information or calculations such as EBITDA (earnings before interest, taxes, depreciation, and amortization). Based on this, John believed he was going to get a great deal for his business and was ready to begin seeking buyers.

John contacted Kruggel Lawton and requested that we put together a formal valuation report that he could share with his advisors and potential suitors. A few weeks later we met with John and had to deliver some disappointing news. The value we determined based on the company’s historical performance was only about 70% of the value John believed his company was worth based on the multiples shared by those friends and business brokers. “What happened?” John asked us.

A Closer Look at the Market-Based Approach

We explained to John that one of the three primary valuation approaches available to analysts today is the “market-based” approach. Based on the principle of substitution, the valuation analyst looks to the market to identify similar businesses or business interests and the related value of those interests. There are two common methodologies:

• Guideline Company Method. In this method, the analyst will perform a search of publicly traded companies in an effort to identify “guideline” companies that are similar to the subject company. Often this involves companies from the same Standard Industrial Classification (SIC) or North American Industry Classification System (NAICS).
• Market Data Method. This approach makes use of actual sales of other private companies based on information entered by an analyst. Sources of information include the Institute of Business Appraisers' Market Data File, Bizcomps and Pratt's Stats. These databases have accumulated data on actual sales of businesses that can be useful in observing the sales prices of other companies in a particular industry. Relevant items of data indexed in the database are price-to-earnings ratios and price-to-gross revenue ratios.

Answering John’s Question: What’s the Problem?

The primary issue we see with these two methodologies when applied generally to a specific business being valued is that we are not necessarily comparing apples to apples. Differences in capital structure, management expertise, size, markets, and deal structure (asset vs. stock sale, real estate included in purchase price or separately valued, etc.), among many other factors, can make significant differences in the ratio or multiple being used. Without knowing these variables, it is very difficult to know what exactly is being valued and how to reconcile any differences. Similarly, values estimated based on “rules of thumb” within certain industries (such as professional service firms are worth approximately one times annual revenues) are hard to delineate without knowing more about the “rules” underlying the ratio or multiple.

Other Valuation Approaches

The two more common approaches used in business valuations include the Income-Based and the Asset-Based approaches.

• The income-based approach draws on the premise that an "equally desirable substitute" for the business being valued would be another investment that would produce an equal amount of economic income with similar associated risks. The income-based approach is based upon the concept of present value. Present value, in this context, refers to the dollar amount that a rational and well-informed investor would be willing to pay today for the stream of expected economic earnings to be realized from owning the investment in the future. Income based approaches can be based either on a capitalization of earnings method (static earnings in perpetuity) or a discounted earnings method (projected earnings for a specific period discounted to present value).
• The asset-based approach involves determining the value of the business based primarily on the balance sheet. It considers the value of the underlying assets and liabilities as a means of determining the value of the business. The three basic approaches are the adjusted net asset value method (used to determine fair market value as a going concern), the liquidation value method (used if the subject company is worth more in liquidation than as a going concern), and the replacement cost method (what it would cost to replace the subject company’s assets).

Conclusion

When done right, the market-based approach can provide meaningful results. But care must be taken in how the underlying data is filtered. As a general guideline, we recommend that business owners be a bit skeptical when friends or advisors begin talking about business values and multiples. We often use the market-based approach as a sanity check to one of the other approaches. Ultimately, the decision on what approach to use, along with many other valuation decisions and assumptions, is best left to an expert. Make sure the individual you hire to perform your business valuation is appropriately credentialed and experienced.