Application software companies are a large industry sector, classified under SIC code 7372 and composed of firms engaged in the development, production and marketing of specialized software products.

In this day and age virtually all industries rely on some form of business software to power their operations. As a result the application software sector continues to grow. As of 2011, some 17,800 US players have chalked up a grand total of over $163B in annual revenues. The industry employs some 255,000 with an average of 15 staff per firm.

While the application software industry is well know for its multi-billion dollar industry titans, most software firms are small to mid-size businesses. In fact, the average application software development company generates close to $10M in annual revenues. About 92% of the companies employ less than 25 people and contribute $19.8B in annual sales to the sector’s total.

Business valuation of application software firms

Given the growth rates often achieved by software firms along with their profitability potential, emerging companies are frequent acquisition targets. Market-based valuation methods are quite common when valuing businesses in this industry.

Valuation multiples relating the enterprise values of comparable firms to their financial performance are the typical tools to appraise a business in this industry. The most common valuation multiples used are these:

• Enterprise value (EV) to revenues (net sales)
• EV to EBITDA
• EV to Property, Plant and Equipment (PPE) assets
• EV to total business assets
• EV to book value of owners’ equity

Example: Using valuation multiples to value an application software company

To demonstrate the application of multiples, we pick a sample software company with the following annual financials:

• Revenue: $10,000,000
• EBITDA: $1,800,000
• Total business assets: $14,300,000

Applying the valuation multiples to each financial measure basis, we calculate the business value as shown in the table below:

In this example the business value estimates across all valuation multiples fall pretty close together. The spread of valuation results can be considerably greater depending on how well the subject business performs against a specific financial measure compared to industry peers.

Estimation of business value by comparison to similar companies in your industry sector is at the heart of the market approach. Many business appraisal experts and business people believe that business value can only be established by market participants – buyers and sellers of business ownership interests.

Valuation multiples are the tools you have to do such comparisons. The multiples are ratios that relate business value to some measure of the company’s financial performance. Typical valuation multiples used in business appraisals are:

• Enterprise value (EV) to gross revenue or net sales.
• EV to gross profit.
• EV to net income.
• EV to EBIT or EBITDA.
• EV to hard assets or total business assets.
• EV to owners’ equity.

Sources of comparable business data for valuation multiples

If you are valuing a private company, there are two central methods under the market approach you can use:

• Comparative private company transactions method.
• Guideline publicly traded company method.

While comparison to private business sales seems compelling, gathering reliable, consistent transaction data is a challenge. There are a couple of reasons for this.

Private businesses are not required to comply with major financial reporting standards such as GAAP or IFRS. Private company owners typically manage their firms to minimize taxes. This tends to obscure the firm’s actual earning power. Without knowing more about each private company selected for comparison, there is no way of knowing if, say, net income or EBITDA can be calculated with any degree of accuracy.

In addition, private company transactions are not required to be disclosed to the public. As a result, a very large number of such deals go unreported. For the purposes of calculating reliable valuation multiples for your comparison these important transactions do not exist.

Advantages of guideline public company method

In contrast, you have plenty of data on similar public companies in your industry sector. First, every publicly traded firm, regardless of its size, is required to make regular filings with the government. In the US, such filings are made with the Securities and Exchange Commission (SEC) and wind up in its EDGAR database.

Equally important, all financial disclosure documents on public companies must comply with accepted reporting standards, such as GAAP. So when you calculate your valuation multiples from such data, your calculations produce consistent, verifiable results.

Discount for lack of marketability (DLOM)

One key difference between the public and private companies is marketability of business ownership interests. To use the guideline public company data for private firm valuation, you need to apply what is known as discount for lack marketability.

For example, let’s assume that an EV to net sales valuation multiple you calculated by analyzing small capitalization public companies is 1.5. Applying a DLOM of 40% to this number gives you a private company valuation multiple of 0.9.

Calculating valuation multiples from guideline public companies: the procedure

To sum up, you can calculate a set of highly relevant valuation multiples for a private company valuation as follows:

Step 1. Identify the industry sector your firm operates in

Come up with the SIC and NAICS codes.

Step 2. Visit EDGAR database

Locate a number of small or mid-size guideline companies similar to yours. In just about every sector there are plenty of small cap public companies that you can include in your comparison data set.

Step 3. Calculate guideline valuation multiples

Decide upon the financial measures for your comparison, such as revenue, EBITDA or business assets. Then calculate the valuation multiples using the guideline public company data you have assembled.

Step 4. Adjust valuation multiples for DLOM

This is important to make your valuation multiples suitable for private company valuation. The typical sources of data for DLOM are the restricted stock and pre-IPO transaction prices compared to sales of fully marketable stock in the same companies.

Step 5. Calculate your company’s value estimates

You can now assess the business value using the valuation multiples developed. Take a look at a typical format for doing so.

One of the most useful business valuation methods under the income approach is the Multiple of Discretionary Earnings technique. Formally known as a direct capitalization valuation method, the Multiple of Discretionary Earnings lets you determine business value based on two key elements:

• Company’s discretionary earnings
• A set of financial and operational value factors

As with any capitalization method, the Multiple of Discretionary Earnings applies a cap rate to the business earnings to come up with a business value number. The difference is how this capitalization rate is calculated.

The approach taken by this method is to build up the cap rate based on your assessment of the business risk factors. Each factor affects your business valuation result to a different degree. Together, this business risk evaluation offers a very comprehensive yet intuitive framework for business valuation.

Here are the business valuation factors, along with a brief description of each:

Business earnings track record

Companies that generate stable, above industry average earnings are more valuable. The higher this valuation factor, the lower the risk that business earnings can decline unexpectedly. The net effect is a greater business value.

Industry growth prospects

Firms operating in rapidly growing industry sectors are more valuable. These days companies in the health services, energy and education are likely to face favorable growth prospects because the demand for these types of products and services is growing.

Business growth prospects

Regardless of the industry your firm operates in, business value depends largely on the company’s earnings growth outlook. This valuation factor is highest for the companies with an outstanding earnings growth track record.

Ease of access to business financing

Financial capital is the lifeblood of successful businesses. Ability to attract and retain required financial resources is key to business success – and directly impacts what the company is worth.

Competitive environment

Businesses that compete in the market segment dominated by a few large, well-funded competitors face tough times ahead. Your company is likely to be more valuable if it does most of its business in highly fragmented market sectors with many smaller competitors.

Location

Location can make or break a business. Great customer access, well-designed premises that invite both new and repeat business tend to go with higher business values.

Customer concentration

Most successful companies try to reduce dependence on a few large customers. Should any one customer be lost, the effect on business earnings is minimal. The more loyal customers a company has, the higher its value.

Product and service concentration

A diverse product and service mix is the hallmark of successful business. This helps companies overcome seasonal variations in demand as well as establish themselves as a one stop shop for many customers.

Market concentration

Much of business success and growth outlook depends on how well it can enter a number of markets. For example, firms with a regional presence are more valuable than local companies. This market diversification reduces business risk and adds to business value.

Business competitive advantages

Sustained competitive advantages such as great technology, exclusive distribution rights or highly loyal customer following are sure value creators for any business.

Business marketability

A business is more valuable if there is considerable demand for similar companies by business buyers.

Ease of operation

A turnkey operation is easier to acquire and, therefore, attracts more potential business buyers and investors. Given the increased demand, the company’s market value is likely to be higher.

Skill and knowledge of staff

Great companies succeed by attracting, training and retaining great people. Such workforce is one of the most valuable business assets.

Quality of the management team

Savvy business decisions that help the company grow are no accident. An experienced management team can steer the business through good times and bad and greatly increase its value.

Insurance claims administrators and risk managers make up a significant part of the independent insurance industry service provider sector.

Some industry statistics

Classified under the SIC code 6411 and NAICS 524282, there are some 215,300 establishments concerned with independent insurance services in the US alone. The industry as a whole employs around 1,125,000 staff generating a total of $188.8M in annual revenues.

The typical insurance services firm is quite small with a staff of just 5 and the annual sales of some $1,000,000. The vast majority of these companies are privately owned.

Insurance administrators provide a range of essential services which include, among others:

• Design and administration of insurance plans for individual and business clients.
• Insurance investigation and fraud prevention.
• Claims administration services.
• Insurance verification and recovery service.

Insurance claims administrators with successful track record of earnings and loyal client base are desirable acquisition targets. Recent business sales give you an excellent basis for determining the fair market value of such firms.

Insurance administrator valuation using multiples

You can create a highly defensible estimate of business value by using valuation multiples derived from such comparable business sales. There a number of multiples to consider:

• 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

Your business value estimate should be based on a number of valuation multiples. Depending on the company’s earnings prospects and risk, each multiple can shed additional light on how the business does compared to similar firms in the industry.

The result is usually expressed as a range of business values, from low to high, along with the median and average values. You can also calculate your company’s value as an average of the figures given by each valuation multiple.

Example: using valuation multiples for insurance administrator company valuation

To show how such market-based valuation works, let’s take a typical insurance administrator service company with these financial parameters:

• Annual net sales: $1,000,000
• Gross profit: $920,000
• Net income: $225,000
• EBIT: $273,000
• EBITDA: $295,500
• Discretionary earnings (SDE): $385,000
• Total business assets valued at: $288,200

We next pick several valuation multiples and apply them to the financials above. Here are our business valuation results:

Each result is different. Why? It depends on how the company in the example compares to its peers for each financial performance parameter, e.g. business net sales, profitability or asset base.

Additional business valuation methods to consider

As a rule, defensible appraisal of an insurance administrator firm should use a number of professionally recognized valuation methods. To supplement the market approach we have shown above, consider using income based valuation methods such as the Discounted Cash Flow. For owner-operator managed firms the Multiple of Discretionary Earnings method is a good choice.

Business goodwill valuation in divorce and partner buyout

Established firms in this industry often create considerable business goodwill. A common problem is how to handle this in cases of marital dissolution in the jurisdictions that treat business goodwill as part of the marital estate. Often the goodwill needs to be separated into its personal and institutional parts based on the statutory or case law in your jurisdiction regarding the distribution of goodwill assets.

Choosing industry specific valuation multiples is one of the biggest challenges in business valuation. When done right, such “apples to apples” comparison offers you a very defensible way to demonstrate what a business is worth.

Typical valuation multiples

You can calculate the estimate of business market value using a number of valuation multiples – each establishing business value in relation to some measure of its financial performance. Here is our short list of the valuation multiples most commonly used to value private businesses:

• Enterprise value (EV) to gross revenues or net sales.
• EV to net income.
• EV to EBIT and EBITDA.
• EV to seller’s discretionary cash flow (SDCF or SDE).
• EV to total business assets.
• EV to owners’ equity.

Do valuation multiples vary by industry?

A key question: just how much do the valuation multiples vary by industry sector? Let’s take a closer look at what such valuation multiples represent.

Business value is about risk and returns. Hence, to measure what a company is worth, you need to estimate both its earning ability and assess its risk. The standard way to evaluate business risk is to calculate the so-called discount and capitalization rates. There are a number of well-known income-based valuation methods that you can then use to appraise a business.

Market valuation multiples are related to this concept. This is especially clear when these multiples are applied to business earnings such as EBITDA or net income. In fact, these valuation multiples act pretty much as the inverse of the company’s capitalization rate – instead of dividing the business earnings by the cap rate, you multiply it by the valuation multiple. The result is the estimate of what your business is worth.

Industry risk premium and valuation multiples

If you take a close look at the Build-Up cost of capital model used to calculate the discount and cap rates for your business, you will see that one key component is the industry risk premium. This additional part of business risk depends, as the name implies, on the industry sector the company operates in.

Businesses in high risk industries are less valuable

The higher the industry risk premium, the lower the valuation multiple. This means that, for a given earnings forecast, the business value is lower. Put another way, the businesses in an industry with high risk premia are more risky and, therefore, worth less.

Valuation multiples by industry – some examples

Just how much do valuation multiples vary by industry? We’ll use the typical Price to EBITDA multiples for several industry sectors to demonstrate the difference:

If you need to value a business based on comparison to recent sales of similar companies, carefully selected valuation multiples are the tools to use. The multiples help you estimate your business value based on the company’s financial performance and actual selling prices of firms in your industry sector.

Since no two businesses are the same, your comparison should be based on a data set of companies that closely resemble the business being valued. You can calculate a number of valuation multiples based on each firm’s actual selling price and financial parameters.

To make these multiples useful for your business value estimation, you would need to do some statistical analysis. The typical format used in professional business appraisals under the market approach is this:

• Calculate the low, median, average and high values for each selected business valuation multiple.
• Apply each valuation multiple to the subject business financial parameters to come up with a business value estimate.
• Use your results to establish a range of business values or average them to report a single number.

Example – using valuation multiples for a private food manufacturing business valuation

To demonstrate the idea, we select a number of valuation multiples to value a small privately owned food manufacturing firm:

Our example business has these financial parameters:

• Business annual net sales of $305,281.
• Gross profit of $170,353.
• EBITDA of $40,248.
• Total business assets valued at $150,466.

Next, we use the weighted average figures for each valuation multiple to come up with the business value result:

This gives us the average business value estimate of $520,231. Alternatively, the business value lies somewhere between $188,361 and $704,181. This type of range is not unusual and can be used to pinpoint the firm’s strengths and weaknesses compared to its competitors.

Our example firm appears to be asset rich, has above average gross margins, but under-performs in terms of profitability.

Valuation multiples lie at the heart of business valuation under the market approach. Each business is different. Yet businesses in the same industry group, of similar size and ownership structure may share a number of important factors that drive their value.

If there are enough data on similar business sales, you can estimate the value of a company by comparing the recent business selling prices. Valuation multiples are ratios that relate the business selling prices to their financial performance. This relative measure of business value lets you calculate the worth of a similar business even if it has never been put on the market.

List of valuation multiples used

Professionals use a number of valuation multiples in their business appraisals. Here is the most common list, grouped by category:

Business valuation multiples based on revenue

These types of multiples are very common in valuations of professional practices and rapidly growing businesses.

• Business price to gross revenue.
• Price to net sales.

Valuation multiples based on profitability

Standard accounting profitability indicators are well known to business people, professional advisors and government agencies. They are often used in formal business appraisals, especially those requiring regulatory filings with the government agencies such as the SEC. Here are top ones:

• Business enterprise value (EV) to gross profit.
• Enterprise value to net income.
• Enterprise value to EBITDA or EBIT.

Cash flow based valuation multiples

Cash flow is the preferred basis for economic business value assessment. Not surprisingly, you will find a number of multiples that help you value a business based on its ability to generate cash flow. Here are some examples:

• Price to seller’s discretionary cash flow (SDCF).
• Price to net cash flow (NCF).

Valuation multiples based on business assets and equity

For asset rich firms in the manufacturing, distribution, and retail industry sectors business assets are usually important indicators of what the business is worth.

In addition, business people may want to know the difference between the book value and economic value of their ownership interests. Typical valuation multiples in this category are:

• Business value to total assets.
• Business value to fixed assets such as furniture, fixtures and equipment (FF&E).
• Business value to owners’ equity.

Choosing your valuation multiples

You have a number of options when choosing the right valuation multiples in you business appraisal. As with any method, the choices are dictated by the purpose of your business valuation and the specific value factors present in the subject business. Here are some thoughts to ponder:

You may choose to focus on the revenue growth potential when valuing a young growing company. The business may be generating respectable sales but not be optimized for top profitability. Some well planned operational changes may well improve its cost structure resulting in higher profits down the road. Valuation multiples based on gross revenue or net sales are a good choice here.

Established businesses being valued for merger or acquisition often rely on the EBIT or EBITDA based valuation multiples. Again, these accounting measures are well known. In addition, they help you value the company regardless of the capital structure used – something that is likely to change anyway following the transaction.

If you are appraising a privately owned business, cash flow is the typical basis. The economic potential of owner-operator managed companies is best assessed using the firm’s discretionary earnings such as SDCF. For larger firms being acquired by a single buyer or private equity firm the net cash flow based multiples are an excellent choice.

Using a number of valuation multiples

You can significantly improve the accuracy of your market-based business valuation by using a number of different multiples at once. You can then apply an averaging scheme to the results you get, or establish a range of possible business values, from low to high.

If you need a fact-based, objective valuation of a private company, market-based methods are an excellent choice. These methods help you establish the value of a business in comparison to recent sales of similar firms. The most widely used methods to conduct such market-based valuation are these:

• Comparative transaction method.
• Guideline publicly traded company method.

To use the comparative transaction method, you calculate the fair market value of your company by comparing the actual selling prices of similar privately owned firms in your industry sector. While the comparisons of this sort can be compelling, the availability and quality of business sales data must be carefully considered.

Reliable stats on private business acquisition deals

Just about any industry has a large number of small publicly traded companies. With proper adjustments for lack of marketability, you can do effective market comparisons using the business sales transaction data on these firms.

Data on public companies tends to be much more plentiful and reliable since these firms must make regular disclosures of their financial condition and merger and acquisition transactions.

Using the data on such small capitalization public companies is at the heart of the guideline publicly traded company valuation method. This technique is especially well suited for valuation of the mid-market private companies in the manufacturing, professional services, education, energy, distribution and retail industries.

A number of business valuation multiples to choose from

Regardless of the method, the tools you can use to calculate the value of a private company are known as business valuation multiples. These multiple are ratios that relate the potential business selling price to its financial performance. Examples of commonly used valuation multiples are:

• Business enterprise value to gross revenues or net sales.
• Business value to gross profit.
• Business value to net income, cash flow or EBITDA.
• Business value to total assets or owners equity.

Calculating the business valuation multiples

To come up with accurate multiples for your business valuation, you need to complete the following steps:

• Gather enough market data on comparable companies.
• Choose which valuation multiples you will be using in you analysis.
• Calculate the multiples from the data you have assembled.
• Make the appropriate adjustments to ensure that the valuation multiples can be used to calculate the value of your business.

Collecting the business sales transaction data

By far the most reliable sources of comparable business sales are the regulatory filings made by public companies acquiring private firms.

In the US, the Securities and Exchange Commission (SEC) requires that all public companies file the DEFM14A and DEFM14C proxy statements relating to a merger and acquisition transaction.

A professionally prepared fairness opinion stating the business enterprise value of the target company is included in such filings. Both domestic and cross-border transactions must be reported. This gives you access to business value estimates in practically all regional and national markets with significant M&A activity.

Since privately owned companies are frequent acquisition targets of public firms, you have an excellent source of audited financial statements and business enterprise values that serve as highly defensible sources of data to calculate your valuation multiples.

The advantages of using such data sources are many:

• Plenty of comparative data. Every acquisition deal done by a public firm must be reported.
• Reliability of data. Audited financial statements ensure that you have a reliable basis for calculating your valuation multiples.
• Defensible data sources. If challenged, you can point to the publicly available records in support of your business valuation conclusions.

Private data services – buyer beware!

This is quite in contrast to private data services that tend to be limited in both the quantity and quality of available transaction data. Business brokers are under no obligation to report private deals, nor are they required to comply with accepted financial reporting standards such as GAAP. Using such incomplete and unaudited transaction records can give you very misleading valuation multiples that result in erroneous and indefensible valuations.

Choosing your valuation multiples

Once you have a sufficient number of comparables around, you can choose which valuation multiples to use. The choice may differ depending on the specific business being valued.

For example, you may choose to emphasize price to asset multiples to value an asset rich manufacturing or real estate business. On the other hand, a professional practice appraisal may call for earnings based valuation multiples such as price to EBITDA or discretionary cash flow.

For a comprehensive market-based business appraisal consider using a number of valuation multiples then averaging the results.

Calculating the selected valuation multiples

Now that you know which multiples you are interested in, calculation should be straightforward. The important point to bear in mind is that, by convention, valuation multiples are based on the so-called business enterprise value.

This means that you determine the business value on a fully marketable, controlling ownership interest basis. This is how private firms are valued. Moreover, this is the way business value estimates are reported in the regulatory filings.

Adjusting the multiples for valuation of private companies

If you have used guideline public companies in your valuation multiple calculations, do not forget to make these adjustments:

• Discount for lack of marketability. Private firms are less marketable than even small public companies. Discounts in the range of 30% – 50% are not uncommon.
• Control premium. Practically all private companies are sold on a controlling ownership interest basis. Market values based on per-share market price of public stock are minority interests that require control premium adjustments.
• Size premium. You can avoid this adjustment by selecting small cap public firms, say below $100M in market capitalization. There are plenty in each industry sector.

Chiropractic clinics are usually classified under the SIC code 8041 and NAICS 62131. Chiropractic practices make up a sizable part of the large professional health practitioners service industry. In the US there are over 49,300 chiropractors in private practice.

The industry sector generates a total of $7.66B in annual revenues, and employs over 148,000 practitioners and support staff. Yet a typical chiropractic clinic is small business: generating around $200,000 in annual sales with an average staff of 3.

Successful chiropractic practices can be a source of highly stable earnings from the repeat business that arises out of an established and loyal patient base. Such cash cow established practices are a frequent acquisition target.

Recent selling prices of similar chiropractic practices give you a way to estimate the market value of your own practice or one you are interested in acquiring.

Practice valuation using multiples

To estimate the value of a chiropractic clinic, you can use a number of valuation multiples. Derived from recent sales of similar practices. These multiples are ratios that relate the actual selling prices to the practice financial performance. Usually, the following valuation multiples are used to value a practice:

• 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

Using a number of such valuation multiples for accurate practice valuation is a good approach. Each estimate may differ depending on how favorably your specific practice compares to its peers. The result can be a range of values. On the other hand, you can come up with an average of all the practice value estimates together.

Example: using valuation multiples to value a chiropractic clinic

To demonstrate the idea, consider a typical private chiropractic practice with the following financial details:

• Annual net sales: $245,000
• Gross profit: $239,000
• Net income: $45,500
• EBIT: $50,000
• EBITDA: $62,000
• Discretionary earnings (SDE): $110,000
• Total practice assets valued at: $45,000

We next select a set of reasonable valuation multiples and apply them to the financial figures above. The practice value results are then:

Note that the results vary quite a bit. This depends on how our example practice compares to its peers for each financial performance parameter, e.g. practice annual sales receipts versus EBITDA.

Other practice valuation methods to consider

A well conducted chiropractic practice appraisal usually relies on several business valuation methods. Since chiropractic clinics can build up considerable practice goodwill, the Capitalized Excess Earnings valuation method is a frequent choice.

Practice goodwill valuation in divorce cases

This is typical in cases of marital dissolution in those jurisdictions that treat professional practice goodwill as part of the marital estate. You may have to divide the goodwill into the personal and institutional parts based on the case law in your jurisdiction regarding the distribution of goodwill assets.

Direct capitalization methods, e.g. the Multiple of Discretionary Earnings valuation method are another good choice for valuation of privately owned chiropractic practices. This method provides a highly consistent way of calculating the practice value based on its earnings and a set of financial and operational performance factors.

A simple answer: because it has a direct bearing on what the company is worth.

The easiest way to see this is to consider how the business value is determined using the well-known Discounted Cash Flow valuation method. The cost of capital is a major input here in the form of the discount rate.

The higher the discount rate the less the company is worth, given a business earnings forecast. In other words, the cost of capital indicates how risky the business is. Higher cost of capital indicates a business that is more risky. To be valuable, the company must generate higher earnings to compensate.

This is just another way of saying that a business investment value is about both the risk and return.