What type of business earnings do you use in private business valuation? The difference could be huge, the results misleading.

Public or private, business value is about returns at a level of risk you can accept. Risk is typically captured in the form of discount or capitalization rates. You can calculate these by using the well-known CAPM or Build-up models. But before you can run your business valuation calculations, the business earnings need to be estimated.

If you pick the discounted cash flow method, the earnings need to be forecast over some future time period, usually several years. Capitalization calls for just one earnings number that should represent the company’s earnings outlook.

Are accounting multiples good enough?

But what type of earnings should you choose in your calculations? The choices are many and confusing. If you look at typical market based valuations for public companies, valuation multiples based on the accounting metrics abound. Price to EBIT, EBITDA, net income, gross revenues or net sales are common.

Private business valuations: Addbacks, normalizations

Yet in private business valuations the typical choices are the Net Cash Flow, abbreviated NCF, and Seller’s Discretionary Earnings or SDE.

Business appraisers talk about the process of financial statement reconstruction or normalization to get at these numbers. Business brokers refer to addbacks.

The reason is that privately owned companies do not need to comply with financial reporting standards, like GAAP or IFRS, unlike the public firms. So one company’s EBITDA may very well be different from another business.

Public firms maximize earnings; private firms minimize taxable income

Creative financial management aside, private businesses pursue very different financial goals from their publicly traded counterparts. While a public company strives to maximize its stock price, and, therefore, earnings per share; the private business owners are mainly concerned with minimizing taxable income.

Private companies don’t pay taxes – the owners do

Private businesses are generally organized as the so-called pass through entities, such as the S-corporations or LLCs in the USA. The companies do not pay taxes, the owners do as individuals. This also helps minimize business taxes as the owners may have additional expenses they can offset against business income to reduce taxes.

Public firms do this by moving operations into tax advantaged geographies, or getting major tax breaks from local governments in return for sizable investments in their communities. If you are a typical small business owner, this is not the game you can play.

Aggressive depreciation skews the earnings for private businesses

A private business has the additional benefit of accelerating asset depreciation. This allows business owners to recover costs quickly. However, it skews the actual asset use and reinvestment picture. Your EBITDA may be affected by such ‘paper expenses’, the D and A in this acronym.

In contrast, public companies are under constant scrutiny by the government. They must clearly demonstrate how they use the invested capital in order to inform their investors properly. The result is typically a much more realistic picture of asset depreciation.

Friends and family borrowing is not commercial terms

Interest expense is also tricky. Private companies may borrow from family members, friends, or business owners themselves on the terms not available in the public market. Public companies borrow money from commercial lenders. Invariably, the terms of such loans represent the current market conditions.

When you compare publicly traded companies, you can review their financial statements that have been prepared by professional accountants, subjected to an audit, and are in compliance with the GAAP (Generally acceptable accounting principles). This is generally not the case for privately owned firms.

Moral: Use Net Cash Flow and Seller’s Discretionary Earnings

As a result, accounting measures of income such as EBITDA or EBIT are not suitable in private business valuations. The business earnings need to be normalized in order to reveal the company’s actual economic potential. The normalization process enables you to establish the company’s earning power. Given your risk assessment, you now have all the inputs required to conduct an accurate and realistic business appraisal.

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