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
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.
If you ever valued a private company, you probably ran across the venerable Multiple of Discretionary Earnings business valuation method. This technique is perhaps the most common in valuing owner-operator managed businesses. Its appeal is simplicity and excellent coverage of value factors that demonstrate what creates business value and how you can improve operations in order to increase business worth.
As this example shows, the Multiple of Discretionary Earnings method lets you assess the company across a set of key financial and operational performance factors. You score the business on each factor, input a set of financial figures, and the method calculates both the earnings multiple and the overall business value.
Better run, more profitable businesses generally command higher selling prices in the market. The Multiple of Discretionary Earnings method captures this trend very well. For example, you may ask the questions:
How much is business value affected by the stability of business earnings over time?
Is the quality of management team important to business value?
What is the effect of customer concentration on the company’s valuation?
Is a business with efficient, well documented business practices more valuable?
The method lets you answer all these questions and more. Importantly, you can spot weaknesses and opportunities to see how much your business value would increase if you made improvements. A great way to make strategic decisions that translate into a greater business value!
But one question remains. Just how high do the earnings multiples get in the ‘real world’? Is there a reasonable range of Seller’s Discretionary Earnings multiples a private business can actually sell for?
This brings us to the area of statistical data analysis. One way you can answer this important question is by studying comparable business sales. You can relate the actual business selling prices to earnings and calculate the earnings multiples observed in the market place.
Conventional wisdom tells us that private businesses tend to sell for somewhere between 0.1 and 4 times the SDE (Seller’s Discretionary Earnings). However, if you analyze the business sales data, you will discover that the range is quite a bit wider.
True enough, close to 90% of private businesses do sell for earnings multiples in the range of 0.1 to 4. But the upper 10% defy this trend.
Indeed, the top 10% of private businesses can price above 50 times the SDE. If you visualize the earnings multiple trend versus the percentile of sold businesses, the graph starts out smoothly, reaching the multiple of 4 for a 90% business sale percentile. Thereafter, the graph trends sharply up, reaching beyond 50 times the SDE for the top 1% of all businesses sold.
This is perhaps an interesting demonstration of the 10% – 90% statistical adage. The highest 90% of the earnings multiples are commanded by the top 10% of all businesses.
What are the reasons for such dramatic differences in selling multiples? Here are some we have noted:
Successful businesses at the top of their game command much higher valuation multiples than their peers.
The best businesses attract the bulk of business buyers and investors who bid up the selling prices competitively.
The top performing companies have the best earnings growth prospects, which directly affect their value.
One statistical reason often overlooked is that in some industries business sales are priced on other measures of financial performance or condition. For example, high technology companies are often acquired based on their assets, especially intellectual property; or their gross revenues.
The earnings multiples could be very high if these companies have not yet been optimized for peak profitability. The acquiring entity, typically a large corporation, may have a very different vision for profitability using its own economies of scale, market access, and capital to grow the young company further.
As you probably know, the Internal Revenue Service is the tax arm of the US Treasury Department. Unsurprisingly, valuation of businesses and other assets is of interest to the IRS. Through the years, the service has published a number of interpretations that have come to be widely supported in professional business appraisals.
These revenue rules, as they are called, do not have the force of law, representing instead the position the IRS takes toward business valuation best practices. As an example, regulatory guidelines may be used in the context of gift and estate tax laws that require appraisers to use specific valuation approaches or methods when valuing privately owned companies.
Some of the IRS publications are merely pronouncements with administrative authority. Again, they do not have the binding force of the law. Examples of these are the revenue rulings, private letter rulings, technical advice and general counsel memorandums.
As time went by, many of these publications were tested by courts in legal disputes. The case law that emerged lent support to some, but not all, IRS pronouncements. Some of the best known and supported IRS publications that stood the test of time are these:
Revenue Ruling 59-60
This publication is perhaps the best known IRS statement on valuation of private company ownership interests.
Deals with the fair market valuation of business intangible assets, including goodwill. The exposition of the so-called formula method is part of this paper.
Updates the Revenue Ruling 59-60 with specifics on intangible asset valuation.
Introduces the concept of lack of marketability and the restricted stock studies as a method to calculate the discounts for lack of marketability. If you are valuing a privately owned company whose stock is less marketable that shares of public companies, this is a very important point to consider.
Provides exposition of discounts for lack of control when valuing partial ownership interests in private companies. If you need to figure out the value of a partner’s share of business, the importance of control in business value estimation is something you should review carefully.
The private letter rulings (PLRs) and technical advice memorandums (TAMs) are the usual way the IRS responds to specific taxpayer inquiries. They are widely used for gift and estate tax valuations.
In general, you will find that many professional business valuations in the USA cite the IRS revenue rulings and other publications to enhance the credibility of appraisal. Remember, however, that the IRS guidelines are less compelling when valuation is done for non-tax purposes such as business sale situations.
If you are considering using the income based methods in your business valuation, you have two main choices: capitalization or discounting. In simple terms, the difference boils down to how you intend to treat the expected changes in business earnings going forward.
In using the discounted cash flow method, you specify the anticipated earnings explicitly in the calculation. On the other hand, the capitalization valuation implies that the business earnings will change at a constant rate in the future. This assumption is rarely met in the real world.
Capitalization also misses the timing of earnings changes. If your target company is likely to experience a rapid growth in earnings, especially early on, it’s best to use the discounting technique to capture it in your valuation.
On a general note, consider some situations that favor one choice of the valuation method over the other:
Steady, evenly growing earnings
If the rate at which the business earnings change is nearly constant then the capitalization of earnings is appropriate for valuation. The accuracy of your results likely would not improve if you used the more complex discounted cash flow technique.
Uneven change in business earnings expected
If you can generate a reliable earnings forecast with significant swings in the cash flow over the years, discounting will produce a more accurate result.
Significant change in earnings, uncertain timing
If your company’s cash flow is expected to change widely and timing of these changes is hard to predict, business risk is increased. The result is a higher discount rate. But since your earnings forecast is less reliable, the capitalization method is just as accurate in this situation.
Rapid business earnings growth over a short period
If your target company is experiencing a growth spurt that you can clearly forecast, use the discounted cash flow method. Once the company’s earnings settle into a more sustainable growth mode, you can make the assumption of constant growth rate in perpetuity. This is a perfect scenario for using the discounted cash flow valuation.
If you ask a business appraiser, you will hear: business value is in the eyes of the beholder. In formal jargon, business valuation results depend on the standard of value you use.
One of these standards is known as the intrinsic value. As the name implies, this is the measure of value one figures out by focusing on the fundamental characteristics that create value in a company. Note that this is very different than the fair market value that is often used by business people when comparing a company to other firms.
Intrinsic value is the price of business ownership that is determined by a valuation analyst following an in-depth or fundamental review of the company’s earning power, assets, and other value drivers.
In layman’s terms, the company’s intrinsic value is its true or real value, something that is revealed after careful consideration of all the value creating factors. An analyst setting out to figure out the company’s real worth will study its products, customer base, competitive position, relationships with suppliers, capital resources, management, skilled staff, among others.
When fair market value and intrinsic value converge
What happens if many serious investors do this analysis and arrive at pretty much the same value number? Now the intrinsic value becomes the company’s market value as these leading investors cast their votes by buying or selling company’s stock at a certain price.
Business valuation – foundation of sound investment
Figuring out intrinsic value for any business is no easy task. It is named fundamental analysis for a reason. If you really want to know what a company is worth, you roll up your sleeves and delve into a rigorous study of all the important elements that create or destroy value in the firm. Your investment decision is then guided by your conclusions: is the company’s stock priced higher, lower or in line with your findings?
Weeding out the hype
This lets you weed out market hype and inflated prices and zero in on value priced companies worth your while. The serious investor is rewarded with insight into promising companies before the market sentiment catches up. You get to hit pay dirt before the gold rush sets in.
Note that the legal definition of intrinsic value may differ from the economic concept. When in doubt and facing a legal challenge, check with your attorney on how the case law or local statutes see it.
Take a look at a professional business appraisal report and you will see the valuation date prominently displayed. Clearly, business appraisers deem this date worthy of mention. Why is this the case?
Business value changes over time
Business value can change quite a bit depending on circumstances that change over time. If you pay attention to the public stock market you will spot the ups and downs in prices as investors become aware of new company information and fluctuations in the economy.
An abrupt drop in company’s profits is a cause for concern and can depress its value significantly. If businesses can’t get required capital on attractive terms, their ability to invest for the future could be impaired. The result is often lower earnings and a drop in business value. A major customer departure could put a kink in a company’s sales and knock its value down.
Beware of valuation multiples that are out of date
If your valuation uses the market approach, comparison to similar companies should be done in a timely manner. Market comps depend critically on your ability to assess the current values of similar companies relative to their revenues, profits, asset bases or equity. As the market sentiment changes, so do the relationships between business financial performance and its value. Stale valuation multiples are one reason business valuations go south.
Business valuation repeated at different times
To make things even more interesting, your business valuation may be done as of several dates. This is common in divorce cases when the parties seek to establish how much business value has changed over the course of marriage of the business owners.
In the unhappy scenario of having to do a business appraisal for litigation, the court may determine what dates you should use. Before taking on the job, consider carefully whether you can do business valuation as of the dates the court wants. You may have little choice but to comply and your ability to complete the valuation engagement could prove critical to your client’s success.
Can you use financial ratio analysis in business valuation? If done correctly, this could be a helpful adjunct in your valuation. Specifically, reviewing financial ratios could help you spot the company’s strengths and weaknesses, and compare its performance to industry peers.
Here are the major groups of ratios to consider in valuing a company:
Short-term liquidity ratios such as current and quick ratio
Activity ratios including the inventory and accounts receivables turnover
Risk analysis figures such as business risk and degree of operating leverage
Balance sheet ratios indicating leverage and equity to asset ratios
Fixed charge coverage ratios, indicating sufficiency of cash flow to cover debt service
Return on investment ratios such as return on total assets and equity capital
You can take advantage of the financial ratios in your business value analysis in a number of ways. Selecting valuation multiples in calculating the company’s market value is one area. The multiples are typically calculated from a data set based on several comparable companies. Riskier businesses tend to be assigned lower valuation multiples, while the firms with better financial performance could command higher valuations.
If your subject company compares favorably in terms of key financial ratios, its value is likely to be at the high end of the range. For example, consistent, stable history of earnings is a good justification to pick higher valuation multiples based on EBIT or EBITDA earnings.
In general, the higher the level of business risk revealed by your financial ratio analysis, the lower the business value, whether calculated on the company’s revenues, assets, or other financial variables.
You can uncover important trends in company’s financial performance by examining the ratios over time. Such trend analysis can help you demonstrate how the company has improved or fallen back within the period. Since business value is a forward looking concept, such trends help you identify significant business risks likely to impact what the business is worth.
If you need to support your selection of valuation multiples, compare your company’s financial ratios to its industry peers. If the company shows strength relative to others, then higher valuation multiples are reasonable. On the other hand, poor financial performance should guide you to choose lower valuation multiples.
Business appraisers usually pick two approaches when valuing a start-up: the income approach and market comparables valuation.
Income valuation challenge: earnings forecast
If you focus on the income approach, be aware of its limitations. Since the young companies have limited track record of earnings, it is challenging to forecast the income stream with any accuracy. Your business valuation is likely to suffer if your earnings forecast fails to match reality.
Market valuation challenge: few comparable companies
For start-ups in new technology driven industries, market comparisons are often limited or non-existent. By their very nature, tech start-ups are technology innovators and often blaze a path unseen by existing companies. Apples and oranges comparisons don’t work too well here.
Despite all these difficulties, start-ups need to be valued for a number of reasons: to grant and value stock options to employees, comply with the tax and financial reporting requirements, attract investment, in acquisition or IPO scenarios.
How to avoid the pitfalls?
Here are some points to bear in mind when valuing a start-up:
Be prepared for a conservative business valuation if you delegate the task to a professional appraiser. The number may surprise you even compared to valuations you got from prior investment rounds.
The reality is most start-ups don’t make it to the IPO. Many more are sold or acquired, or close their doors. Your business valuation will likely reflect this as a possible outcome.
Your start-up valuation is always made at a certain point in time. Just because the company was worth more in the past, does not mean its value has grown by a desired amount. Your appraiser may spot headwinds on the horizon or challenge your earnings or market share growth assumptions. The result may be a business value lower than you expected.
If your start-up goes public and its value jumps, don’t assume your private valuation of a year ago was wrong. Public companies with stock traded openly on the market are worth more than their private counterparts. The reason is stock liquidity, which attracts many more investors, and drives up the stock value.
As the company gains momentum, its earnings forecasts become more supportable. So your business appraisal is likely to be more accurate. This holds true for successful start-ups. If you are the proud founder of a successful start-up, congratulate yourself. Take a look around and note that many competitors of yesteryear have fallen by the wayside.
Successful and rapidly growing start-ups are likely to attract the attention of large public companies. This increases the appetite for ownership of these young firms, and drives up their valuation.
Business people, investors, and creditors pore over financial statements to make decisions. If you are a business owner, you look at the company’s financials to see how well it has done, and what investments are needed to achieve its goals in the future. Investors, of course, want to know if the value of their investment is growing. And creditors are interested to make sure their money is safe.
Notice that all these needs depend upon the future outlook for the company. Will the business generate enough income to pay its owners? Will the growth in business earnings justify the money invested? Will the company have enough funds to pay off its loans?
The central question is: where does all this money come from? Firstly, from business revenues. Revenues must be compared against the business operating expenses as well as the capital required to support its sales and expansion plans.
So how can a business meet its cash requirements? Here is the short list:
By generating cash flows from operations
By selling shares of its stock
By borrowing from creditors
By selling some of its assets
If you consider borrowing from a commercial lender, you will quickly discover that their view of business comes with a large dose of skepticism. Bankers expect the worst, so they try to protect their interest assuming the worst case scenario for the company. Should the business cash flow fall too low, how will the loan be repaid?
The typical answer is by selling some business assets. That’s why the lender is likely very interested in the value of business assets. Note that this is very different from the book value carried on company’s financial statements. The real question for the lender is this: should the company fail to come up with cash for loan repayment from its profits, what can certain business assets fetch on the market if offered for sale?
In other words, the lender is interested in the liquidation value of business assets. The book value of depreciated assets shown on the company’s books is not helpful here.
As the saying goes, if you are not selling your business assets, you are buying them. The market value of these assets is what your company owns. Find out what the assets are worth before asking a banker for a loan.
Capitalization of business earnings is very common. The idea is to use the expected economic benefit for a single time period, usually a net cash flow projected for a year right after the date of business appraisal. Going forward, the business cash flow is expected to change at a constant rate year over year.
If this constant earnings growth assumption is not realistic for your company, you should use the discounting technique in your valuation. In such situations, you project business earnings for a number of years and apply the discount rate to determine the business present value, or what is is worth today.
The advantage of discounting is that it lets you determine the value of a company whose earnings are not constant and do not change at a fixed rate over time.
Beyond a certain point in time, the accuracy of your forecast diminishes. A typical way to handle this lack of certainty is to assume that business earnings would change at a sustainable constant growth rate in perpetuity. Hence, the business value is the sum of the discounted earnings forecast and the capitalized residual value beyond the forecast horizon.
Unsurprisingly, the discount and capitalization rates are closely related:
Note that the discount and capitalization rates become equal if business earnings don’t grow.
Valuing businesses by direct capitalization is very popular because it is so simple. All you have to do is estimate the net cash flows for a single year, and then apply the capitalization rate to calculate the value. While the discounting is a more general way to value a business, it requires that you estimate a set of business earnings for a period of time, say 5 – 10 years into the future, and then use the discounting method to calculate your value result.
Your business valuation is as accurate as the assumptions you make. For example, if you decide to use capitalization, check if the business earnings are likely to change at essentially a constant rate going forward.
On the other hand, your earnings forecast will drive the accuracy of the discounted cash flow valuation. If the projection is not realistic, you can easily overestimate or underestimate the company’s true worth.