Business valuation multiples: using coefficient of variation to choose the best one

One way to value a business is by comparison to recent sales of similar businesses. As a result, you can estimate your business value from such market comps using valuation multiples.

A wide range of valuation multiples to choose from

These multiples are ratios that help you determine your business market value in relation to the company’s financial performance. For example, you can estimate your business worth based on its revenues, earnings, cash flow, EBIT, EBITDA, equity or asset values.

Which valuation multiples are more accurate?

Given the choice of valuation multiples, you may wonder: are some multiples more accurate for estimating your business worth?

Yes indeed! Since the valuation multiples are statistically derived, you can easily assess the accuracy of each – and choose the best.

Range of business values and coefficient of variation

Professional business appraisers pay close attention to the so-called coefficient of variation. It is a ratio of the standard deviation to the average value of a given valuation multiple.

The reason this is important is this: the smaller the coefficient of variation, the closer the actual business selling price multiples cluster around the average.

If you use the valuation multiple with the low coefficient of variation, your business value estimate is likely to be more accurate since it falls into a narrow range.

Another way to look at this is that the business people in your industry tend to price business sale deals using such valuation multiples.

Example: picking a multiple to estimate the value of a restaurant

Let’s take a look at an example. We are looking to estimate the market value of a privately owned family restaurant. The restaurant grosses \$1,500,000 in annual sales, throws off \$250,000 of discretionary cash flow, has \$100,000 of inventory and is located in the Los Angeles area.

The typical choices of valuation multiples for this business are:

• Business sale price to gross revenues.
• Business sale price to seller’s discretionary cash flow.

So which one is the best choice?

We study the sales of privately owned restaurants regularly. The recent numbers show that the coefficient of variation for the above two valuation multiples are:

• Gross revenue-based: 0.554.
• Discretionary cash flow-based: 0.509.

The average multiples will vary with a number of factors, including the restaurant size, location, and specific market niche. A reasonable approximation for our example business is around 0.3 times the gross revenues, and 1.7 times the cash flow, plus inventory.

Here are our estimates for the restaurant market value:

• Gross revenue based – around \$550,000 (including the inventory).
• Discretionary cash flow based – around \$525,000.

Since the coefficient of variation for the cash flow-based multiple is lower, you should first consider the second restaurant value estimate – in this case \$525,000.