If you need to get an objective estimate of business value, consider using the valuation multiples derived from the recent sales of similar businesses. There are a number of advantages:

1. Business valuation with multiples is easy to understand and explain.
2. In times of economic uncertainty, business people and professional appraisers carefully consider the market trends when valuing a business. Market value estimates using the valuation multiples are an excellent way to do so.
3. If the business is to be bought or sold, market comparisons are a must to defend your asking or offer price.
4. Market comps are also a great way to prove your point if your business valuation is challenged.

Types of valuation multiples

Business appraisal experts and seasoned investors use quite a number of valuation multiples depending on the specific business or the reasons for business valuation. Here are the most common choices:

• Valuation multiples based on business gross revenue or net sales.
• Gross and net profit-based valuation multiples.
• Earnings based multiplies relating the business value to its EBIT, EBITDA, or discretionary cash flow.
• Valuation multiples based on business assets and owners’ equity.

Reasons for choosing the earnings-based valuation multiples

Business valuation is about earnings and risk. For small owner-operator managed companies, the discretionary cash flow based multiples are the usual choice. For larger small and mid-market businesses the typical basis is EBITDA. There are a couple of reasons why the EBITDA based valuation multiple is often preferred:

• Business owners have control over the company’s capital structure. Hence, the interest expense is viewed as discretionary and added back to calculate the available cash flow.
• Many private firms are structured as pass-through entities for tax purposes, such as S-Corporations or LLC companies in the US. Since these companies do not pay tax directly, adding back the taxes makes sense.
• Depreciation and amortization are paper expenses and do not affect the business cash flow. They are added back to calculate EBITDA.

To sum up, EBITDA is a good way to represent the available business cash flow to calculate the value of private companies. The EBITDA-based valuation multiples are a common choice in valuing larger businesses in these industries:

• Manufacturing firms
• Technology companies
• Professional services businesses

Current EBITDA valuation multiples for major industries - some examples

As the market conditions change, so does the value of your business. Valuation multiples based on recent business sales help you track changes in your company’s market value. Here are some typical EBITDA valuation multiples by industry:

The EBITDA multiple for software companies may seem high. However, these firms tend to show considerable variation in earnings. It is a good idea to check your results using other valuation multiples. For example, these firms tend to price at about 2.5 times the net sales.

If you turn to a commercial lender for a business loan, expect the focus to be on the company’s cash flow. In other words, the lender wants to know whether the business will be able to repay the loan from its profits and cash flow.

Lender’s view of value: ability to repay plus valuable collateral

Just in case this assumption does not work out, the lender will want the business owners to put up sufficient collateral - typically in the form of valuable business assets. Should the loan repayment become a problem, the lender will lay a claim on these assets.

Loan to value depends on how quickly the assets can be converted into cash

For a lender it is important to establish the marketability and values of the business assets pledged against the loan. The more easily the asset can be converted into cash, the higher the loan to value figure.

You can expect the bank to offer around 80% of the value of current accounts receivable. On the other hand, most lenders will likely offer just around 50% of the value of business furniture, fixtures and equipment (FF&E) assets.

Inventory is another business asset that the lenders scrutinize carefully. For a manufacturing company, the bank is likely to lend against the values of raw materials and finished goods inventory. In the event of default, the finished goods can be sold off to a jobber, while the raw materials usually can be returned to the supplier or sold at a discount to a competitor.

Since the bank is not in a position to complete the production, the work-in-progress inventory is usually not a good collateral.

Experienced lenders are well aware that some inventory may be slow moving. In the event of default, this type of inventory is much harder to convert into cash quickly.

Good inventory control records are very important if you are to get high loan to value figures for inventory. Writing off obsolete inventory has the additional advantages of reducing your property taxes and insurance costs.

Conservative commercial lenders are also likely to apply a haircut to inventory levels in excess of the industry average. The assumption here is that the business inventory value is likely overstated or partially unmarketable.

Business valuation results depend on the premise of value!

A major cause of disagreements between business owners and lenders is how the value of pledged business assets is determined. Business appraisal can be done under several premises of value. Depending on the choice of premise, the business valuation results and, therefore, the amount of business loan, can vary dramatically.

Lender’s position: liquidation premise of business value

Expect the lender to take a conservative position and use the so-called liquidation premise of business value. This establishes the worst case scenario in the event the business fails to repay the loan and the collateral needs to be liquidated quickly.

Business owners’ view: going concern

For the owners of a going concern business, the typical premise is value in use. The resulting business valuation is considerably higher than under the liquidation assumption.

Both the business owners and the lender are right. However, each party is viewing the business value from a very different perspective!

Business people often ask us: “Are different business valuation methods used to value companies in different industries?” It is a very sensible question - after all the differences between, say, a manufacturing firm and a dental practice are profound.

Professional business appraisers have developed an elegant, powerful framework to deal with this challenge. At the core of this framework are a set of universal busines valuation methods that can be applied to valuing any business.

All these methods are grouped under the three major approaches to business valuation:

• Asset - based on the values of individual business assets and liabilities.
• Income - based on the company’s earnings outlook and risk profile.
• Market - by comparing the subject business to similar companies, in the same industry segment, that have recently been sold.

There are several reasons why this business appraisal framework can handle any business:

• All standard business valuation methods consider the industry-specific value drivers.
• These valuation methods provide a consistent way to measure business value while accounting for the unique attributes of your business and its industry.
• Each standard valuation method offers a different way of measuring the business worth, complementing the results you get from other methods.

Support by major business appraisal standards

The power and flexibility of this business valuation framework have made it the de-facto standard in all professionally conducted business appraisals. In addition, the multi-method business valuation is supported by the key appraisal standards such as the USPAP, AICPA SSVS No 1, and the IRS Revenue Ruling 59-60.

Let’s take a quick look at the typical valuation methods that are used to value companies in just about any industry:

Asset based valuation methods

The Asset Accumulation method lets you determine the overall business value based on the valuation of individual business assets and liabilities.

Current market values of these assets and liabilites are used to create the appraisal of a business. Needless to say, these market values are defined by the industry-specific factors. Examples are prices paid for similar equipment, royalty rates charged for customer lists or licenses and property rental costs.

Capitalized Excess Earnings method is another asset based valuation technique that is especially useful in measuring the value of business goodwill. Again, the industry conditions affect the market value assessement of individual business assets along with the capitalization rates used by this method.

Income based valuation methods

This group of appraisal techniques is perhaps the best example of how the industry factors affect the business value. Both capitalization methods, such as Multiple of Discretionary Earnings, and discounting techniques, such as the Discounted Cash Flow method, require business risk assessment. The industry-specific risk is one element of the discount and cap rates used by these valuation methods.

Income based valuation also requires that you forecast business earnings. This will most certainly be affected by the trends in your industry segment.

Market based valuation methods

These appraisal techniques rely on comparison to sold businesses in your industry segment. As a result, the business value estimates reflect the industry conditions such as investor demand for similar companies.

As a rule, business investment requires careful assessment of industry-specific growth prospects and risk. Hence, by using the market-based valuation multiples derived from similar business sales, you are effectively relying on the judgment of other business people about what a company in a specific industry is worth.

Since each method takes a different view of business value, throwing several standard methods into the mix is a very good idea. In fact, the use of multiple valuation methods is expected of all professionally prepared business appraisals.

Business Valuation using Several Methods

When it comes to valuing a business, size matters. The main reasons for this is that companies of different sizes face very different risks. Most investors believe that large companies are less risky than their small counterparts. Other things being equal, the smaller firms need to generate higher returns to compensate their investors for the extra risk they take.

How much more risk? The largest Fortune 500 firms with market capitalizations approaching $500M are about as risky as the overall market. On the other hand, for businesses that are valued well below $150M, the investors currently demand the additional risk premium of around 9.5%. That’s the bracket where most small businesses fit in.

Here are some reasons for this risk perception difference:

• Large companies have better access to debt and equity capital.
• Larger firms tend to be more diversified in their product and service offering.
• Small companies usually have a relatively limited market reach.
• Large firms with deep pockets are often preferred by customers who look for a stable, long-term vendor.
• Large companies have an easier time attracting top management and skilled talent.

How company size affects its value

To illustrate, we will use the well-known Build-Up model to calculate the capitalization rate for a fictitious Fortune 500 company and a small business. We will assume that both firms are debt-free and their earnings grow at 5% per year. Both companies are in the general merchandize retail industry, SIC 5399.

In this example we have included the company specific risk premium of 4% for both firms.

The valuation multiples above tell a remarkable story: the large company commands the valuation ratio that is almost twice as high as its small business counterpart!

In other words, it takes almost $2 of business earnings for the small company to contribute as much to its value as $1 for the Fortune 500 firm.

One of the key factors that affects the value of a company is the industry in which it operates. The question is why and by how much?

The answer is risk. In fact, the industry-specific risk premium is one of the elements that make up the discount and capitalization rates for your business. Here are the key factors that define the industry-specfic risk:

• Overall industry growth prospects.
• Barriers to competitive entry such as initial capital investment, licensure requirements or unique know-how.
• Consolidation trends and degree to which large competitors dominate the industry segment.
• Technological changes that may require considerable investment to stay competitive.
• Regulatory compliance requirements that can suddenly drive up the costs of doing business in the industry.
• Emergence of new competitive threats domestically and internationally.

How much can the industry-specific risk affect the company valuation?

In 2009 the lowest risk industries such as the educational services under the SIC code 82 showed negative industry specific risk premia of around -4%. This means that the companies in this industry sector faced risks below the overall market!

On the other hand, the high risk industry segments, for example the transportation services under SIC code 47, called for the risk premia on the order of 4.3%.

Given the typical discount rates of some 25% for privately owned firms, this could make a difference of more than 8% and greatly affect the valuations of companies in these industries.

Example: effect of industry specific risk on company valuation

To demonstrate the effect of industry risk on company valuations, we will pick two firms with identical earnings forecasts for the next 5 years.

One of the firms is in the educational services sector, the other is a transportation company. To make the comparison easier, we will assume that both firms have the same company-specific risk profile that adds another 4.1% to their discount rates.

Here is the earnings forecast:

• Year 1: $150,000.
• Year 2: $175,000.
• Year 3: 185,000.
• Year 4: 200,000.
• Year 5: $225,000.

Using the well-known Build-Up model, we calculate the discount rates for the two companies as follows:

• Educational services: 18.94%
• Transportation services: 27.47%

We apply the Discounted Cash Flow business valuation method to calculate the value of both companies. Here are the results:

The business value difference is amazing: with the same earnings prospects the educational services firm is worth almost twice as much as its transportation industry counterpart!

If you talk with professional business investors or business brokers, soon enough you will hear them mention business valuation ratios. Business appraisers refer to these tools as valuation multiples.

Basically, the ratios are a technique to estimate the value of a business based on comparable business sales. Such market-based valuation tools are very useful in a number of situations that call for a defensible, objective business appraisal:

• Business sale or purchase. Buyer and seller can justify their valuations based on the objective, empirical evidence.
• Legal disputes which often require that the fair market value of a business be determined. Again, objective market proof of business value is a great way to resolve disagreements.
• Tax issues such as gift, estate and income taxes. Tax authorities are very keen on checking the market data to verify the business appraisal results submitted by tax payers.

Typical ratios used in business valuation

Since no two businesses are the same, the actual business selling prices will differ from one transaction to another. Relating the selling prices to the business financial performance measures is the best way to develop reliable ratios for your business valuation.

As you can expect, the business income statement and balance sheet items are the usual choice of basis to calculate the business valuation ratios. Here are the most common ones:

1. Business selling price to gross revenues or net sales
2. Price to gross profit
3. Price to net income
4. Price to EBT, EBIT and EBITDA
5. Price to seller’s discretionary cash flow or net cash flow
6. Price to fixed business assets or total asset base
7. Price to owners’ equity.

The accuracy of each business valuation ratio varies by industry, company size, and the time frame when the business sale comps have been selected. The best ratios are those showing the smallest spread of values, from low to high. This indicates that business people rely on some business valuation ratios more when pricing the actual business acquisitions.

Choosing the ratios for your business appraisal: best practice

One way to develop a highly defensible market-based assessment of your business value is to use several ratios or valuation multiples at once. Each will produce a result indicating what your company may be worth based on the specific financial performance measure.

You can then use these valuation results to come up with a solid estimate of business value. Let’s say that the lowest business value for your company as determined by the price to gross revenue valuation ratio is $1,000,000; the intermediate value based on the discretionary cash flow is $1,100,000; while the highest is $1,250,000 as indicated by the price to net income ratio.

You can conclude that the market value of the business will fall somewhere in the range established by these numbers, in this case $1,000,000 - $1,250,000.

On the other hand, the numbers can be averaged to give a single number for the business value: $1,116,667.

In fact, both the range and a single value number reporting is industry-standard for professional business appraisals.

Privately owned and operated florists are a major part of the retail industry. Classified under the SIC code 5992, there are around 35,650 such establishments in the US alone. The industry as a whole generates an impressive $6.6B in annual revenues and employs over 135,000 people.

Yet an average flower shop is a classical small business: producing around $200,000 in annual sales with a staff of 4.The industry is highly fragmented with the top 5 companies accounting for less than 2.5% of the total industry revenues.

Key value drivers for retail florists

The product for flower shops is arranged cut flowers that usually account for over 50% of a store’s revenues.  Florists with significant commercial accounts that tend to result in stable recurring revenues are valued above the average.

Another key value driver is an attractive store location with the rent expenses below 6% of the shop’s gross revenue. The highest valued flower shops are located away from the major “big box” competitors such as do-it-yourself home improvement or grocery chain stores.

The florists that focus on the special event and gift market segments tend to command higher business valuations. Essentially, such flower shops differentiate on superior service that leads to customer loyalty, higher profitability and, not surprisingly higher business value.

Sales from an online presence or phone orders tend to be more cost-effective ways to generate sales. Some of the most valuable flower shops achieve close to 80% of their revenues through these channels.

Business valuation methods for flower shops

Florists with a track record of highly stable, above average earnings are very desirable and sell often. If you study such business sale comparables, you can develop a very good idea of what your business is worth.

The typical tools to estimate your business value is to use the valuation multiples derived from such business sales. The multiples relate the actual flower shop selling prices to their financial performance.

Thus, you can calculate your business value in relation to its revenues, profits, EBIT, EBITDA, cash flow, assets or owners equity.

Here are the typical valuation multiples used to estimate the value of a flower shop:

• Business value based on gross revenue or net sales.
• Business value based on net income.
• Business value based on EBIT and EBITDA earnings.
• Business value based on the seller’s discretionary cash flow.
• Business value based on the furniture, fixtures and equipment assets.

Flower Shop Valuation using Business Sale Comps

Example: valuing a flower shop using valuation multiples

To demonstrate the idea, let’s pick a typical retail florist business with the following financials:

• Business gross revenue: $250,000.
• Business net sales: $225,000.
• Net income: $35,553.
• EBIT: $36,000.
• EBITDA: $39,500.
• Seller’s discretionary cash flow: $154,247.
• Furniture, fixtures and equipment assets: $25,307.
• Inventory: $4,601.

We pick a set of reasonable valuation multiples to calculate the value of the business as follows:

Other methods to use for valuing a florist business

You can value an established owner-operator run flower shop by the well-known Multiple of Discretionary Earnings method. This income-based business valuation technique lets you determine the value of the business based on its earnings outlook and a set of key financial and operational performance factors.

Since many privately owned florists are lifestyle businesses, the Multiple of Discretionary Earnings is particularly well suited for their business valuation.

For a florist that has created an solid reputation in its market, the value of business goodwill can be considerable. To appraise such a business, consider using the Capitalized Excess Earnings method, known as the Treasury Method. This technique is specifically intended to help you determine the value of business goodwill and total business value.

If you are like most business people, CPAs, brokers or investors, you probably take the actual business selling prices as a strong indication of what a similar business is worth.

In fact, the market approach to business valuation relies on such selling prices comparisons for a good reason:

Business selling prices offer an objective evidence of how other business people determine the value of businesses.

A large enough number of arms-length business sales is also a good way to establish the fair market value of your business. This is useful even if you do not plan to buy or sell the company.

Here are some key situations where the fair market value is the de-facto standard for business appraisal:

• Gift and estate taxes
• Divorce and other legal disputes
• Buy-sell agreements
• Employee stock ownership plans (ESOPs)

That said, the question is this: just how well do the recent selling prices of similar firms represent the value of your business?

Business selling price: key elements

First, some points about the elements that can make up the business sale price:

1. Buyer down payment
2. Seller financing
3. Lender financing
4. Earnout
5. Key employment agreements
6. Non-compete agreements with outgoing management or owners

Whether all these elements exist in a given business sale deal can make a material difference to the contract business selling price.

Business market value is affected by deal financing

In just about any industry, seller-financed deals tend to result in higher selling prices. If the deal can be financed through a commercial bank loan on attractive terms, the business selling price is likely to reflect it as well.

Typically, the business selling price includes the seller and lender financing at face value, i.e. not discounted over the time it is paid off. Arguably, the cash value of a financed deal is lower than an all-cash business sale.

Earnouts are usually excluded from the business selling price

By convention, the earnouts are excluded from the broker-reported business sale price. That’s because the earnout is contingent upon some future events and may not be paid in full measure or not at all - if the business fails to achieve the objectives agreed upon between the seller and buyer.

Other valuable parts of the business selling price

On the other hand, the employment and non-compete agreements with management and key staff are usually included in the selling price.

Private business value is determined based on total invested capital

Another important rule in valuing small businesses is that the value is established on the total invested capital basis. This includes both the owners’ equity and long-term debt.

That is very different from the public company valuation multiples that are typically computed on the owners’ equity basis only. If the company being valued uses debt financing, the resulting valuation results can be very different!

Get a defensible business value number by following established conventions

Since these conventions are followed by most professional business appraisers, it is wise to stick with them - if you want to avoid the challenge by other business people, tax authorities or courts.

Check your valuation multiples

Valuation multiples derived from market comps are the tools you can use to estimate your company’s fair market value. You can calculate it in relation to your firm’s financial performance such as revenues, gross and net profits, EBIT, EBITDA, business assets or owners equity.

When you use such valuation multiples, you need to be aware how they are calculated. Otherwise, your business value estimate may be way off. 

If you want to get a top quality business appraisal, consider using several well-known business valuation methods.

Such a multi-method business valuation is standard in professionally prepared appraisals. Since each method represents a different view of how business value is measured, reviewing the results from several different methods gives you a comprehensive picture of what the business is worth.

In practice, you can choose some valuation methods over others because they are more suitable for your specific situation. Here are the typical method choices used for valuing established service firms:

• Valuation multiples based on comparable business sales
• Multiple of Discretionary Earnings valuation method
• Discounted Cash Flow method
• Capitalized Excess Earnings method

Using market comps to value a service business

Successfull companies in the services industry sell often. Hence you can do valid market comparisons to recent business sales to see what your business is worth.

The valuation multiples are ratios that help you estimate the market value of a business based on the actual selling prices of similar firms and your company’s financial performance measures. Business value is usually measured against the firm’s revenue, profits, cash flow, EBIT, EBITDA, business assets or owners equity.

Valuing a company by direct capitalization of earnings

Smaller service businesses, especially those with mostly recurring revenues, can be valued using the Multiple of Discretionary Earnings method.

Discounting cash flows to determine business value

For larger firms or those experiencing significant earnings fluctuations over time, the Discounted Cash Flow method may be more appropriate.

Valuation of business assets: tangibles and goodwill

Business goodwill can be a big part of the total asset base for service companies. To determine the value of goodwill, consider using the Capitalized Excess Earnings method, also called the Treasury Method.

Establishing business value

The results you get by using the various business valuation methods may differ. This is quite normal since each method uses a different set of rules to determine business value.

You can use your results to establish a range of business values, from low to high. On the other hand, you can average your business value results and come up with a single number. Both techniques are very common in professional business appraisals.

One of the most difficult situations that often call for a business appraisal is divorce. Just about any jurisdiction considers business ownership interest a property that is part of the marital estate. As such, it must be distributed among the spouses.

In the US, the family courts follow two standards on how the property in the marital estate is to be divided:

1. Community property
2. Equitable distribution

Under the community property standard, all assets acquired during a marriage are treated as jointly owned by the married couple. They are thus divided into equal parts upon divorce.

Those jurisdictions that adopt the equitable distribution standard may or may not treat the business ownership interests as equally divisible. The courts have considerable discretion when deciding which party gets what share of the property.

Business valuations at different dates may be needed

In some cases the courts may treat business ownership acquired separately as part of the marital estate. To determine if the business value has appreciated during the marriage, the court may require that two business appraisals be performed:

• Initial valuation of the business at the beginning of the marriage.
• Re-valuation of the business at the time of divorce.

If the business value has increased over time, as demonstrated by the two business appraisals, a spouse may be able to claim part of that value, especially if that spouse was actively contributing to the business.

Needless to say, business value changes over time. In a lengthy proceeding, the valuation date can make a big difference to the amount of the final property distribution. Ask your lawyer if the court is likely to accept the business value:

• As of the marriage date
• On separation
• When the divorce is filed
• At the time of the court proceedings.

How business value is measured in a divorce

To make matters more interesting, courts do not have one standard of value. In reality, the following main standards of business value have been used in divorce cases:

Investment value

Under this standard of business value, the argument holds that the divisible property should be valued at what it is worth to its present ownership, i.e. the married couple.

Fair market value

The proponents of this well-known standard maintain that one spouse should not be compelled to pay more or less than what the business can fetch if put on the market.

Intrinsic value

Used less often, this standard of business value requires an in-depth analysis of the business fundamentals to detemine what the company is worth.

Fair value

Defined by the legal system, this standard tends to be subject to the court’s interpretation. In fact, the fair value of a business may be equivalent to any of the above standards of value, depending on the jurisdiction.

Business valuation methods for divorce

As in most situations that call for a business to be appraised, you have a number of choices among the three valuation approaches:

1. Asset - based on the values of business assets and liabilities.
2. Income - based on the company’s earnings outlook and risk.
3. Market - where the firm’s value is established in comparison to the sales of similar businesses or professional practices.

Business goodwill valuation in divorce

In many cases involving ownership of established businesses and, especially, professional practices, the question of business goodwill is of major concern.

A common business valuation technique used in marital dissolution situations is the Capitalized Excess Earnings method. Known as the Treasury Method, this technique offers a consistent way to determine the value of business goodwill and total business value.

This is important becase of the way a particular court may handle business goodwill. Here are some common possibilities:

• Treat business goodwill as part of the marital estate and, therefore, distributable among the parties.
• Split the goodwill into the personal and institutional parts and handle only the institutional portion as distributable.
• Exclude business goodwill from the marital estate altogether.

Since business goodwill is often a large part of the total business value for many professional service firms, the amount and handling of goodwill can make a major difference to the final settlement!

Use of multiple business valuation methods is typical in divorce cases

It goes without saying that a comprehensive, defensible business appraisal is critical in divorce situations. Using a number of established business valuation methods, you can ensure the value of a business is accurately determined and can be defended in court.

Under the income approach, the courts consider both the capitalization and discounting valuation methods. Generally, direct capitalization valuation, such as the Multiple of Discretionary Earnings method, is best suited for companies with a track record of stable earnings. The Discounted Cash Flow method is the preferred choice for valuing young businesses or firms whose earnings vary considerably over time.

Market comparisons to recent sales of similar businesses offer an excellent and highly defensible basis to value your business. In cases of privately owned businesses, comparisons to similar private firms is the preferred technique, known as the Comparative Transaction Method.

Defensible business appraisal is a must in divorce

More business appraisals are thrown out of court due to insufficient evidence or supporting information than any other reason. It behooves you to get all the facts together and review any business valuation critically if it is destined for a family court.

Discounts to business value

Depending on the jurisdiction, your business valuation may need to be adjusted for these factors:

• Discount for lack of marketability of a privately owned business.
• Discount for lack of control, if a spouse owns less than a controlling interest in the business.

Classified under the SIC code 8011, the primary care physician practices are part of a large professional health practitioners service industry. In fact, there are over 373,000 medical practices in the US alone.

The industry as a whole generates some $202B in annual revenues, and employs over 3,000,000 professional and office staff. However, a typical medical practice is small business: producing around $600,000 in annual sales with an average staff of 8.

Medical practices tend to generate highly stable earnings due to the repeat business that arises out of an established and loyal patient base. As a result, established practices are a frequent acquisition target. Selling prices of similar physician practices offer you an excellent way to estimate the market value of your own practice or one you are interested in acquiring.

Market based practice valuation using multiples

In order to estimate the value of a medical practice, you can use a number of valuation multiples. Derived from recent sales of similar practices, the multiples relate the actual selling prices to the practice financial performance measures. The typical valuation multiples used in appraisals are:

• Selling price to net annual sales
• Price to gross profit
• Price to net income
• Price to EBIT and EBITDA
• Price to total practice assets
• Price to owners’ equity

It is a good idea to use a number of such valuation multiples for accurate business valuation. Each estimate may differ depending on how well your specific practice does compared to its peers. The result is a range of values, or some weighted average of all the practice value estimates together.

Example: using valuation multiples to value a primary care medical practice

Let’s consider a typical private medical practice with the following financials:

• Annual net sales: $600,000
• Gross profit: $585,000
• Net income: $80,000
• EBIT: $82,500
• EBITDA: $84,000
• Total practice assets valued at: $250,000
• Book value of owners’ equity: $11,000

For this example, we pick a set of reasonable valuation multiples and apply them to the financials. The practice value results are as follows:

Note the considerable variation in the results. That’s because our example medical practice compares less favorably with its peers when it comes to the owners’ equity measure and profitability.

Other business valuation methods to consider

To be defensible a medical practice appraisal usually relies on a number of business valuation methods. Since physician practices tend to create considerable business goodwill, the Capitalized Excess Earnings valuation method is a common choice.

Practice goodwill valuation: a common requirement in divorce cases

This is especially so in cases of marital dissolution in those jurisdictions that treat professional practice goodwill as part of the marital estate. You may have to split the goodwill into the personal and institutional parts depending upon the way the court in your jurisdiction handles the distribution of goodwill assets.

Direct capitalization techniques such as the Multiple of Discretionary Earnings valuation method are another common choice for valuing owner-operator managed physician practices. The method provides a very consistent way of calculating the practice value based on its earnings and a set of financial and operational performance factors.

Valuation using a Set of Standard Methods

If you are considering an outside investment for your business or looking to put money into a promising company, business valuation is surely to be one of the key data points in your decision making.

Significant investments are usually made in order to achieve some strategic goals such as increasing the business revenues, entering a new market or developing the next generation products.

Business valuation - a forward-looking exercise

The value of the business is thus driven by its future earnings. It also depends on the level of risk the company is likely to face as it pursues its plans.

Perhaps the most widely used business valuation methods for investment purposes are the income-based discounting techniques. The best known of these is the Discounted Cash Flow method. It enables you to determine the business value today, known as the present value, based on three fundamental inputs:

1. Future earnings forecast over some period of time, e.g. 5 years.
2. Discount rate which captures the business risk.
3. Long-term or terminal business value - or what the business will be worth at the end of the forecast period.

Savvy investors usually are very good at assessing the company’s prospects and risk. Since they consider a number of investment projects, they have an idea about the kind of return on investment they expect.

Put another way, they see the discount rate as the rate of return they require to become interested in a business investment.

Comparison of business value and investment - Net Present Value

One common technique these investors use is the Net Present Value calculation. It combines the Discounted Cash Flow business valuation with a direct comparison to the value of the proposed investment.

If the difference between the business value and the amount of investment is positive, the investment makes financial sense.

A special case is when the business value is equal to the investment value. The discount rate that makes this happen is known as the internal rate of return, or IRR for short. At this rate of return the business creates precisely the amount of value that justifies the investment.

Internal rate of return as a decision making tool

You can use the internal rate of return as a screening tool for a proposed investment.

If you are a business owner considering an outside investment, you should know both the amount of investment and the rate of return the investor expects. You can use the Net Present Value calculation to see if your business can grow in value to make the cut.

If you are thinking of investing in a company and have the size of investment in mind, then you can use the Net Present Value calculation to see if the business can create enough value to meet your required rate of return on investment. 

Using Net Present Value in a number of what-if valuation scenarios

Time value of money can make a major difference here. You can run a number of scenarios with different cash-out assumptions. Is an early exit a better strategy than waiting longer as the business value grows? The Net Present Value calculation helps you make such important decisions in a precise, fact-based manner.

ValuAdder gives you a set of standard tools to determine the value of a business, structure an acquisition deal, and make sound investment decisions.

Business Valuation System

One of the most challenging tasks you are likely to face when considering an outside investment is how to determine the value of your company.

Referred to by venture capitalists as the post-money valuation, this key step gives you a number of strategic decision data points:

• What the entire company is worth, known as the enterprise value.
• How the business ownership interests are split between the founding team and external investors.
• Whether the founders retain the controlling ownership of the company after the investment has been made.
• Is the investment worth taking given its effect on business value?

Business valuation of a high growth firm - First Chicago Method

Since the infusion of outside capital is likely to change the business earnings prospects going forward, the Discounted Cash Flow method is the standard choice for investment-driven business valuation.

This income-based valuation method lets you focus on the company’s earnings prospects and risk directly. The result is the “present value” of the firm - what it is worth today.

The additional capital can make a major difference to the business’s earnings prospects. Since the future is uncertain, it is best to create a number of forecasts and run your Discounted Cash Flow valuation for each:

1. Best case - under the most favorable assumptions of business performance.
2. Base or most likely case.
3. Worst case - if the business encounters unexpected “head winds” in the near term.

You can view the results as a range of possible business values or average them to come up with a single valuation number.

Business Valuation based on Cash Flow and Risk

Note that this valuation analysis is inherently forward looking and involves a number of subjective assumptions on your part. It is a very good idea to check the market in order to confirm your valuation results. Recent sales of comparable businesses give you an objective evidence of selling prices.

If you relate the business selling prices to the the firms’ financial performance, you can see how the market values these companies. More importantly, using the valuation multiples derived from the market comps you can estimate the market value of your own business.

Valuing a Business based on Market Comps

This combination of the comparative market value analysis and Discounted Cash Flow valuation is known as the First Chicago Method.

The method’s power is in combining the theoretically precise yet subjective business valuation based on its income prospects with a highly objective “reality check” of business market value based on the actual business sales.

You can easily implement the First Chicago method using the ValuAdder business valuation software:

• Select the Market Comps tool for your market-based valuation.
• Create a number of Discounted Cash Flow valuation tools, one for each valuation scenario.
• Calculate your business valuation results.

Our customers ask us often: “what computer systems can I run ValuAdder software on?”

Our answer: any computer you like! This is no exaggeration - you can conduct your business appraisal using ValuAdder software on all versions of Windows, Apple MAC OS, Linux or Unix computer systems.

Industry-standard environment for business valuation software

How is this possible? The short answer is: Java. All ValuAdder software products are built on top of the industry-standard Java 6 computing platform. Invented by Sun Microsystems, Java has become the de-facto standard for enterprise quality software applications world-wide.

Enterprise valuation software quality for businesses large and small

It is used and supported by the Fortune 500 industry leaders including IBM, Oracle, HP, CISCO, Google, eBay and many others. Through the Open Source Java Community Process, Java stays on the cutting edge of software innovation and runs on millions of computers throughout the globe.

What does this mean to you? In short, the proven track record and quality business appraisal software that you can depend on regardless of your choice of a computer system to use.

Business valuation software quality you can rely on

The fact that Java is used by millions of business people gives you a proven platform on which to run your ValuAdder business valuation software tools. Thousands of software engineers contribute to continuous innovation to make Java the most secure, reliable and high performance way to do your business valuation analysis.

You get the same consistent performance and dependable results from ValuAdder whether you run the software on a leading edge Windows 7 machine or earlier versions such as Windows XP.

On a MAC OS X computer ValuAdder looks and behaves as a true Apple application - just as you would expect. And, of course, this includes the latest MAC OS X.6 Snow Leopard systems. Thank you, Apple engineering team, for making this possible!

Immediate help as you do your business valuation

State of the art software is nothing unless it offers help right when you need it. Your ValuAdder comes equipped with an extensive integrated Learning and  Information Center that leverages the power of the Java Help system.

This gives you two tools in one - a powerful business valuation analysis tool and a flexible learning system. Whether you are new to business appraisal or a seasoned veteran, ValuAdder adapts to make your task of valuing a business easier and more time efficient.

As computer systems evolve so does Java. We already have full Windows 7 support - on the eve of the release of this new Windows system.

Business valuation tools that capture the spirit of innovation

As you work on a business appraisal using ValuAdder you are benefiting from the talent and dedication of a global community of software engineering professionals that made the Java software possible.

Tools for Business Valuation

If you talk to a professional business appraiser, it won’t be long before you hear about the business valuation approaches and methods. These are the tools of the trade - and it is important to understand their relationship.

Business appraisers enjoy having an arsenal of tools at their disposal. This gives them the flexibility to appraise just about any type of business or professional practice. Much of the appraiser’s expertise is in the proper selection of the right tools for each assignment.

Being highly organized people, the business appraisers like ordering things. So here is the basic taxonomy of the business valuation tools.

Business valuation approaches

At the top of the pile are the three ways to measure the value of a business:

• Asset Approach
• Income Approach
• Market Approach

Each approach lets you adopt a different view of what a business is worth. As the name implies, the Asset Approach looks at the values of business assets in order to determine the value of the entire company.

The Income Approach lets you measure the value of a business based on its ability to generate earnings at an acceptable level of risk.

Finally, the Market Approach offers you the way to estimate the market value of your business - by comparison to similar businesses that have recently sold.

Business valuation methods

When it comes to the actual calculation of business value, the business appraiser reaches to an array of techniques known as methods. Each major approach has a number of methods under it. The methods are the actual computational procedures you can use to calculate the monetary value of your business.

Here are the major business valuation methods grouped around their approach:

Asset-based business valuation methods

• Asset accumulation method
• Capitalized excess earnings or the Treasury Method

Income-based business valuation methods

• Discounted cash flow method
• Capitalization of earnings method
• Multiple of discretionary earnings method

Market-based business valuation method

• Comparative transactions method
• Guideline publicly traded company method

Best practice: multi-method business valuation

The methods differ in the fundamental approach and the details of the calculations. Since no method is better than the others, well-prepared business appraisals use a number of methods to round out their conclusion. Using a set of methods under each Approach is the best way to “cover all bases” - and get a highly accurate, defensible business apppraisal.

Multi-Method Business Valuation

Our customers often ask us this question:

ValuAdder offers a number of business valuation methods. Does using multiple valuation techniques reduce business risk?

Our answer is this: applying a number of methods to value a business helps you reveal and assess the business risk much better than using just one method.

Appraising a business based on its cash flow

Let’s say that you are valuing a company and decide to use the Discounted Cash Flow method. This method relies on the discount rate for business risk assessment. The classical Build-Up model to calculate the discount rate works as follows:

1. Start with the risk-free rate of return. The yield on long-term US Treasuries is a common choice.
2. Add the equity risk premium - the additional return you get investing in the stock market.
3. Add the premium for company size - since smaller firms tend to be riskier than Fortune 500’s.
4. Add the industry-specific risk premium.
5. Assess the company-specific risk and add the corresponding premium.

Usually, the company-specific risk assessment is the hardest part, and the greatest cause of mistakes. Needless to say, improperly calculated discount rate will give you erroneous business valuation results.

A different perspective - market based business valuation 

To verify the results your get with the Discounted Cash Flow method, you may consider using the market-based valuation techniques. Here, you study the recent sales of comparable companies. You can see how other business people assess risk by calculating the valuation multiples they applied when valuing the businesses they bought or sold.

Review of statistically derived valuation multiples gives you an idea of the levels of risk for companies similar to yours. While each business is unique, sharp deviations from the industry norm call for an explanation and may point out an error in your analysis.

Asset based business appraisal - another view of business value 

You can also add asset-based valuation methods to shed further light on business risk. For example, using the Capitalized Excess Earnings Method shows just how well the business generates returns for its owners, given the capital invested.

Notice that the various methods adopt a very different view of business value. Yet all these different perspectives complement each other to expose the same fundamental drivers of business value - risk and return. 

Business Valuation using Multiple Methods

If you want a business appraised by a qualified business analyst, you are presented with a bewildering array of choices. There are no local or federal license requirements for business appraisers.

Instead, a number of professional organizations offer education and professional certifications for appraisers. Each organization has its own set of appraiser endorsement requirements and guidelines on how its members should conduct business valuations for clients.

Just about all these organizations follow the accepted standards, most notably the Uniform Standards of Professional Appraisal Practice or USPAP for short, which are published by the Appraisal Standards Board of the Appraisal Foundation.

Here are the major business valuation organizations that train and certify appraisers in North America:

American Society of Appraisers

Founded in 1952, ASA is perhaps the most recognized professional organization of business appraisers. It covers a number of disciplines including the appraisal of real estate, machinery and equipment as well as business valuation.

The accredited members receive a number of designations:

• Accredited Member or AM.
• Accredited Senior Appraiser or ASA.
• Fellow of the American Society of Appraisers, abbreviated FASA.

In addition to extensive coursework and qualifying exam, these designations require significant full-time business appraisal experience.

The Society has local chapters throughout the US and Canada.

Institute of Business Appraisers

IBA has been founded in 1978 with the purpose of educating and certifying appraisers with the primary focus on small businesses and professional practices. The Institute offers extensive business valuation training. Those completing the training and successfully passing an exam can receive these designations:

• Certified Business Appraiser, CBA.
• Business Valuation Accredited for Litigation, or BVAL.
• Fellow of the Institute of Business Appraisers, FIBA.

American Institute of Certified Public Accountants

AICPA views business valuation as a specialized type of accounting services. In addition to publishing the major business appraisal standard, AICPA SSVS No 1, the Institute offers a full-fledged certification program for its CPA members who wish to practice business appraisal.

The accreditation conferred is known as Accredited in Business Valuation or ABV. It requires that the members complete several valuation related courses and successfully pass a two-day exam.

National Association of Certified Valuation Analysts

NACVA, founded in 1991, has members that are mainly CPAs and non-CPA appraisers in private practice as well as government service. Extensive training and qualification exam are offered leading to the Certified Valuation Analyst (CVA) accreditation.

The Canadian Institute of Chartered Business Valuators

The leading business appraisal organization in Canada, the Institute offers in-depth training and rigorous examination to certify its members as Chartered Business Valuators (CBV). Additional educational requirements are typically a college degree.

If you need a recipe for an accurate, defensible business valuation make sure you choose a number of professionally accepted business valuation methods to do it.

Valuing a business requires that you carefully analyze the company across a number of economic fundamentals. Professional business appraisers approach business valuation in three ways:

1. Asset approach
2. Income approach
3. Market approach

Selecting and applying a number of proven valuation methods under each approach gives you a comprehensive view of the business value.

Using the asset-based methods such as the Asset Accumulation or Capitalized Excess Earnings, you can determine the company’s value based on the values of its assets.

The income valuation methods let you estimate the value of the company based on its earning capacity and risk. On the other hand, the market based appraisal methods focus on comparison of your business to similar firms that have sold recently.

All these methods take a different view of what drives business value. No one method is better than the other. That is why selecting a number of valuation methods is the best way to create a sound business valuation.

Given all the method choices, which ones should you pick? This depends on your specific business situation. Here are some suggestions:

Start-up valuation

Valuing a young company presents unique challenges. Since most comparable business sales involve established firms, it makes little sense to use the market-based valuation methods.

Asset based valuation methods focus on establishing the value of the business based on a proven, optimized asset base. Often, business goodwill is a large part of business value, especially for businesses in the service industry. Yet it takes time to build goodwill in a business.

A start-up’s value depends on its potential to generate future earnings at an acceptable risk. This leaves you with the income-based valuation method choices. One of the best ones is the Discounted Cash Flow method. You can calculate your business value based on a number of earnings forecasts, each with its own risk profile represented by the appropriate discount rate.

Business valuation of an established cash cow company

Established firms that tend to generate reliable, steady income streams are very desirable. As a result, they are frequent acquisition targets. This gives you plenty of business sale comparables data to make an accurate business market value assessment.

Direct capitalization methods, such as the Multiple of Discretionary Earnings method, are an excellent choice for valuing companies with stable, recurring earnings.

Steady earnings tend to be associated with a large, loyal customer base. The business becomes an institution in its market place which creates considerable goodwill. You can use the famous Treasury Method to calculate the value of business goodwill and total company value.

Valuing an owner-operator managed small business

If your business operates in the service, retail or wholesale industries, comparable business sales abound for small, successfull companies. Market based business valuation methods work very well in valuing such firms.

The Multiple of Discretionary Earnings method is a very common choice under the income approach. In addition to the business earnings, the method lets you determine the business value based on a number of financial, operational and lifestyle factors.

Professional practice valuation

Professional practices are a special type of service firms. Perhaps the biggest difference is that they tend to create considerable business goodwill. If you need to appraise a medical or dental practice or an accounting firm, the Capitalized Excess Earnings method should be high on your list.

For larger practices the Discounted Cash Flow method is the typical choice. On the other hand, you can value a single practitioner firm using the Multiple of Discretionary Earnings method.

If you own a small animal veterinary practice, consider buying one or plan to open a new clinic, here are some interesting industry statistics.

Classified under the SIC 0742 code, there are over 37,000 vet practices in the US alone. The industry as a whole generates some $12.2B in annual revenues and employs more than 264,000 people. The average vet clinic is quite small - generating around $300,000 in annual sales with 7 professional and support staff.

Key value drivers for a veterinary practice

While each vet practice is unique, a number of common factors contribute to the practice value. Here is the short list:

• Practice size. Multi-doctor vet practices tend to be more valuable than a single practitioner clinic.
• Location. Practices located in urban areas usually command higher valuations.
• Specialty area. Small animal veterinary clinics are generally more marketable than large animal practices. As a result, small animal vet practice valuations are typically higher.
• Asset base. Most vet practices sales are asset sales. A clinic with significant furniture, fixtures and equipment assets is likely to command a higher valuation.
• Market position. Well-established clinics can create considerable business goodwill. These practices tend to be above average in client profitability and client retention. As a result, their valuations are usually above the industry norm.

Business valuation methods for veterinary practices

As with many other professional service firms, you can value a veterinary practice using a number of methods under the standard asset, income and market valuation approaches.

Successful vet practices are frequent acquisition targets. If you need to determine the market value of your clinic, comparison to recent selling prices of similar practices is a good choice.

You can calculate your business value based on the practice’s financial performance and the valuation multiples derived from comparable practice sales. These multiples are ratios that relate the actual practice selling prices to its revenues, profits, cash flows, assets or owners’ equity.

Here are the valuation multiples commonly used in valuing veterinary practices:

• Sale price to annual net sales or gross revenues.
• Sale price to EBITDA and EBIT.
• Sale price to net income.
• Sale price to seller’s discretionary earnings (SDE).

Example - valuing a private veterinary practice using valuation multiples.

Let’s consider a typical vet clinic with the following financials:

• Practice annual net sales: $300,000.
• EBITDA: $56,000.
• Net income: $33,000.
• Seller’s discretionary earnings: $110,000.

We pick a set of reasonable valuation multiples and estimate the practice value as shown in this table:

By convention, these practice value estimates include most business tangible assets and goodwill. The value of real estate, cash, and receivables is not included - a common arrangement in an asset sale of a professional practice.

Other business valuation methods you can use

Even if you need an informal business valuation check for your practice, it is always a good idea to use several valuation methods. No one method is better than the other. The combination gives you a solid coverage and much more reliable estimate of practice worth than a single calculation.

If you plan to share your practice appraisal with other business people, tax authorities or legal experts, a multi-method practice valuation is a must.

For valuing a small owner-operator managed veterinary clinic, consider using the venerable Multiple of Discretionary Earnings method. This income-based valuation technique lets you calculate your practice value based on its earnings and a number of key financial and operational performance factors.

An established clinic may have built up substantial business goodwill. You can calculate the value of goodwill using the Capitalized Excess Earnings method, known as the Treasury Method.

If you are negotiating with professional investors or lenders, the Discounted Cash Flow method should be among your choices. This formal business valuation technique is the common way to determine the value of a professional practice based on its earnings outlook and risk assessment.

Veterinary Practice Valuation using a Set of Methods

Private law practice ownership transfers have been on the rise in recent years. Not surprisingly, the issue of valuing a law firm has gained in importance.

In the US private law firm sales are endorsed by the American Bar Association under the Model Rule 1.17. A growing number of states now permit the sale of a privately owned law practice.

Recent sales of law practices offer you a defensible way to estimate the value of your law firm. Valuation multiples derived from comparable law firm sales are a  common way to value a law practice. Price to gross revenues is the most typical multiple used to assess the practice value.

Law practice goodwill - a large part of practice value

More than many other professional service businesses, private law firms tend to develop considerable goodwill. This is very important since the overall practice value is affected by how transferrable the goodwill is. As in all professional practices, goodwill is actually made up of two parts: the personal goodwill and the practice goodwill.

Law firm value is driven by goodwill tranferrability

The distinction is significant because it is generally much easier to transfer the practice goodwill to the new owners. Personal goodwill, as the name implies, is created by the individual porofessionals.

Client loyalty translates into repeat business for an established law practice. The question is: what happens when the current owner leaves the law firm?

Client retention and earnouts

Client retention is one indication of how well the practice retains its value over time. Private law practice sales often entail earnouts. Under an earnout arrangement, a portion of the law firm’s sale price is held back for a period of time. If the client retention goals are met, the amount held back is paid to the sellers.

Law firm value depends greatly on its size

Market-based valuation multiples vary to a large extent by law firm size. It is not unusual for a law practice grossing over $1,000,000 in annual receipts to command a price to gross revenue valuation multiple greater than 1.5 times.

For smaller firms grossing under $300,000 the valuation multiples rarely exceed 0.5 times the annual revenues. Again, one reason is that the larger law firms tend to do a better job of creating the practice goodwill. In contrast, most of the goodwill in a small law firm is personal in nature.