If you are looking at valuing an owner-operator managed small business, then the Multiple of Discretionary Earnings business valuation method should be high on your list of priorities.
One of the best examples of the so-called direct capitalization valuation methods, this method determines the value of a business as a multiple of its discretionary cash flow.
One of the greatest strengths of this well-known business valuation method is an excellent match it provides between the business earnings and a broad range of financial and operational performance factors.
You can get very accurate business valuation results with this method. Equally important, you can see how the business value is affected by the quality of the operation.
Balance sheet inputs that affect business value
For highly accurate results, you also need to provide several financial values from the company’s recast balance sheet. These include:
- Net working capital.
- Non-operating assets.
- Long-term liabilities.
For the purposes of your business valuation, Net Working Capital is the difference between the business current assets, less inventory; and its current liabilites, less the short-term portion of the long-term debt. Essentially, this represents the liquid capital used by the business owners for short-term financing.
Non-operating assets may include such items as business-owned real estate, excess inventory and underutilized production or distribution capacity. The idea is that the business asset base should be adequate to support its level of earnings. All assets that are not used to generate these earnings are extra – and can become additional and valuable parts of a business acquisition.
If you value a debt-free business, the long-term liabilities are zero. However, if the business uses financial leverage, then your business valuation must factor in these liabilities. The result is the value of business owners’ equity interest in the business.
If you bought or sold a small business before, you may notice that Multiple of Discretionary Earnings method measures the business value on an asset sale basis. In fact, most small business sales are asset transactions.
In these cases, the business assets, less cash and trade receivables, transfer to the buyer. The seller pays off all business liabilities to deliver these assets free and clear. Non-operating assets may be valued separately and included in the deal.