Importantly, the direct capitalization methods, such as the well-known Multiple of Discretionary Earnings method, use a single number as its earnings input. Coupled with a matching choice of capitalization rate, which captures business risk, the Multiple of Discretionary Earnings method produces very accurate business valuation results.
A big advantage of this method is that it automatically matches your business earnings and the capitalization rate – a key requirement for accurate business valuation.
Multiple of Discretionary Earnings uses seller’s discretionary cash flow as its earnings basis and lets you specify business risk based on a number of essential financial and operational business performance factors.
So how do you choose the business earnings number? There are several choices to consider:
Simple average of SDCF taken over several years.
Weighted average SDCF value.
Squared weighted average SDCF value.
Your choice depends on which way of calculating business earnings best represents the business income prospects going forward.
For example, if the earnings don’t change much year over year, a simple average of SDCF over the last 3 – 5 years is a good choice.
On the other hand, the weighted average and, to a greater extent, squared weighted average schemes put stronger emphasis on the most recent business financial performance. These choices are best if your business earnings changed significantly in the last few years.
A custom weighting scheme may be good if you want to handle unusual years – those showing business earnings that are either much higher or lower than normal.
Let’s say that you need to value a business with the following seller’s discretionary cash flow history over the last 3 years:
Year 1 (earliest): $100,000
Year 2: $135,000
Year 3: (most recent): $159,000
Based on your analysis, the business shows average performance across all 14 financial and operational performance areas considered by the Multiple of Discretionary Earnings business valuation method. Given this, you decide that, on a scale of 0 – 4.0, the business gets a rank of 2.5 in each area.
Business net working capital is $50,000; and it has no long-term debt. Business leases its premises and, in your judgement, carries no excess assets.
Scenario 1: Business valuation result using the simple average to calculate the earnings basis
In this case, your business earnings are just the sum of the 3 annual values divided by 3:
($100,000 + $135,000 + $159,000) / 3 = $131,333.
Using this value along with the $50,000 for the business net working capital and setting all performance weights to 2.5 produces the following business valuation results:
Business Value = $378,333.
Scenario 2: Business valuation result using the squared weighted average to calculate the earnings basis
This time, you decide that business earnings in the more recent past are better indicators of what the business will likely earn in the future. You select the weights of 1, 2 and 3, square them, and calculate your earnings input as follows:
($100,000 x 1 + $135,000 x 4 + $159,000 x 9) / 14 = $147,929.
Your business value calculation now produces a different result:
Business Value = $419,823.
This is around 11% higher than the result you got with the simple average earnings in Scenario 1 above. No surprises here: your earnings input is higher.
What this means is that you expect the business earnings to be in line with the higher values seen in the more recent years. This business growth upside is correctly captured by your Multiple of Discretionary Earnings business valuation.
Each approach takes a different view of how business value is measured. To calculate business valuation results, professional business appraisers use a number of methods under each approach.
Picking your business valuation methods
It is a good idea to use several business valuation methods to calculate your business value. Each method has advantages and no one method is more accurate than the rest. Here are just some things to consider when picking your business valuation methods:
Asset-based methods such as the Capitalized Excess Earnings method work well when you need to determine the value of business goodwill. Also, these methods are an excellent choice if you need to allocate the business purchase price among business assets.
Income-based business valuation methods come in two flavors: direct capitalization and discounting. The direct capitalization methods, such as the Multiple of Discretionary Earnings method, are a frequent choice to value established small businesses with a solid history of earnings.
On the other hand, the Discounted Cash Flow method is very often used to value young start-ups or companies going through a period of rapid growth.
You may want to consider market-based business valuation methods if you need to defend your opinion of what your business is worth. Knowing what similar businesses sell for is often the strongest indication of a business’s fair market value.
Business value conclusion: combine your results into a single number
Don’t be surprised if the results your get from the different methods vary. The benefit of using several methods is to see what the business value is from different points of view.
To come up with a single number for business value, business appraisers use a weighting scheme. The result from each business valuation method gets a weight based on its relative relevance. For example, if you believe that market comparisons are very important in your situation, you can assign a higher weight to your market-based valuation result.
As an illustration, let’s say that you used 3 business valuation methods and got the following business value results:
Discounted Cash Flow: $1,200,000.
Capitalized Excess Earnings: $1,350,000.
Comparative business sale transactions: $1,270,000.
You believe that the asset and income-based valuation results deserve an equal weight, while your market comparisons are twice as relevant. Here is your weighting scheme:
Discounted Cash Flow: 25%.
Capitalized Excess Earnings: 25%.
Comparative business sale transactions: 50%.
Now you can multiply the business valuation method results above by their weights and sum it all up:
$1,200,000 x 0.25 + $1,350,000 x 0.25 + $1,270,000 x 0.5 = $1,272,500.
If you need to present your business valuation results in a professional appraisal report format, you will find that the newly released Business Valuation Report Builder V2.0™ is the tool for the job.
Professional business valuation reports that comply with the USPAP standards
Starting with a 40+ page report template in the familiar Microsoft® Office Word format, the Report Builder™ takes you through the process of preparing a standards-compliant business appraisal report in record time. And you can create your reports on a Windows or Mac computer.
Here is how the Report Builder™ simplifies creation of your business valuation reports:
Gives you the power and flexibility of a fully editable Microsoft Office Word template format.
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Business owners and buyers often conduct business valuation as part of a successful business sale or purchase. Yet there may be a difference between the economic value of a business and its actual selling price.
But if you plan to buy or sell your business, you still need to address the issue of business affordability, given a specific set of business sale terms, known as the deal structure. A key question here is:
Given the business price and terms, does the business generate sufficient earnings to make its acquisition financially feasible for the buyer?
Business brokers often say that the terms of the business sale are more important than the selling price. Seller financing is one key differentiator – a deal that is at least 50% seller-financed can have a selling price that is over 20% higher than an all-cash business sale scenario.
In addition to seller financing, the major factors that affect the business affordability and, therefore, its selling price include:
Compensation requirements of the new ownership.
Required payback period on the business buyer’s down payment.
Capital expenditures expected in the near term.
Additional buyer funds needed for working capital.
Business acquisition examples – deal terms matter!
As an illustration, consider these acquisition example scenarios:
Let’s say that you have determined that the business you want to buy is worth $750,000 and is expected to generate $250,000 in annual discretionary cash flow going forward.
You decide to make an offer reflecting this business value. You estimate that you will need to spend $15,000 to close this transaction. You expect the typical asset sale transaction, so you will need to provide additional $40,000 as the working capital.
The business seller is prepared to finance 20% of the purchase price over 3 years at 7.75% annual interest. A bank is prepared to fund 30% of the deal over 5 years at 8% interest. The bank also expects a debt service coverage ratio of 1.25 on all borrowed capital.
This means that you need to come up with the remaining 50% of the purchase price.
In addition to $60,000 annual compensation, you would like to see your down payment back in 4 years. You also estimate that the business will need new equipment in the next few years, an additional $15,000 in annual capital outlays.
Business purchase terms that do not work
Here is the summary of your business purchase scenario:
Offer price: $750,000
Closing costs: $15,000
Working capital: $40,000
Down payment: 50% of the deal.
Seller financing: 20% over 3 years at 7.75% interest
Bank financing: 30% over 5 years at 8% interest
Payback period on down payment: 4 years
Your annual compensation: $60,000
Annual capital investments: $15,000
You can use the Deal Check calculation in ValuAdder to verify if all the terms above make financial sense. This calculation shows the following:
Your annual debt service will be $119,080. To make the deal work, the business must generate annual discretionary cash flow of $325,475.
Clearly, this does not work because the business throws off a cash flow of only $250,000.
Business acquisition terms that make financial sense
Now let’s see what happens if the deal terms are changed as follows:
Offer price: $750,000
Closing costs: $10,000
Working capital: $40,000
Down payment: 20% of the deal.
Seller financing: 60% over 8 years at 6.0% interest
Bank financing: 20% over 10 years at 7.5% interest
Payback period on down payment: 5 years
Your annual compensation: $60,000
Annual capital investments: $15,000
How did you get there?
You were able to negotiate better seller financing terms, which reduced your initial cash outlay. The bank is also much happier with the generous seller financing and offers you better loan terms. Besides, you decided to do some of the due diligence work yourself, reducing the closing costs. You can wait an extra year to get your down payment money back.
Your debt service is now $98,485 and the business annual discretionary cash flow requirement is just $230,107. This works fine given the $250,000 in available business cash flow.
Note that, without changing the purchase price, your new deal terms reduced the required annual business cash flow by $94,368! It also transformed a non-starter into a sound business acquisition offer.