One of the easiest and most defensible ways to approach valuation of a private company is to compare against the recent sales of similar businesses.
If the companies that have actually sold resemble your business closely, you can come up with a number of business market value estimates based on the so-called valuation multiples.
These multiples are ratios that relate the company’s financial performance to its potential selling price and, therefore, its fair market value.
One valuation multiple that is used often is the business price to its gross revenues. Others include value measures based on the company’s net profits, gross margin, EBITDA, cash flow, assets, and value of business owners equity.
Given the wide choice of valuation multiples, when does the price to gross revenues ratio work best to value a private company? Here are the typical situations:
High growth company valuation
A company that is focused on revenue growth may not yet be optimized for profitability. Hence, its value lies in its ability to generate sales. Valuing such a company on its gross revenues is a good choice.
Technology based company valuation
A special case of high growth businesses, the technology companies invest heavily in intellectual property development and marketing. It is not unusual to see negative returns for quite some time – even for companies with a commanding market share.
If you want to develop an estimate of market value for a technology company using business sales comparables, the gross revenue tends to be a more accurate basis than current profits or cash flows.
Professional practice valuation
Medical and dental practice valuations often rely on the practice sales as the preferred basis. One reason is that established practices tend to show similar profitability given the level of revenues.
Another key reason is that the value of a professional practice is most directly related to its ability to attract and retain clients. Gross revenues from client billings thus offer an excellent basis for estimating what a practice is worth.
Valuation multiples change over time – some surprises
We study the private business sales data all the time and run into quite a few surprises when selecting the best valuation multiples for our clients.
As market conditions change in an industry, business people tend to change their attitude to what drives business value.
A large group of business investors known as financial buyers tend to value companies based on their profitability. They are less likely to be impressed by business revenues, unless their expectations of returns and risk are satisfied. Financial buyers tend to use valuation multiples that are based on business cash flow, EBIT, EBITDA, and net income rather than revenues.
One example is the food and drink industry. Our analysis of restaurant sales in 2008 shows that business buyers have relied on the price to discretionary cash flow valuation multiples when pricing acquisition deals.
This is a shift from a year ago when most deals were priced using the gross revenue based valuation multiples.
Recent sales of private businesses are an excellent source for estimating your business value. See how to determine the business value based on its gross revenues, net sales, profits, cash flow and assets.
See Example »
To get an accurate business valuation you should not limit yourself to using just a single valuation multiple. In fact, you can appraise any business three ways:
- Based on the business income generating capacity.
- Based on the company’s asset base.
- By comparison to sales of similar firms.
Look at a professionally prepared business appraisal report and you will see that several methods are used to calculate what the business is worth.
See How to Value a Business Three Ways
If you are valuing a CPA practice, consider using the tried and true tools – valuation multiples derived from the sales of comparable accounting practices, classified under SIC code 8721.
The advantage of taking this market approach to an accounting practice valuation is twofold:
- It offers highly defensible evidence of the current selling prices for CPA practices.
- It captures the risk including the important industry and firm size risk premia as well as the discount for lack of marketability.
Top valuation multiples used for CPA practice appraisals
While there are a number of economic and accounting bases you can use to estimate the CPA practice market value, most acquisitions are priced using just a few valuation multiples:
The first valuation multiples are by far the most common ones. In fact, the coefficient of variation for the Price to Net Sales valuation multiples is just under 0.27 which is less than 10% that of the EBIT based number.
This indicates that the variation of the CPA practice selling prices around the mean is much smaller when the net sales basis is used. Put differently, your peers tend to trust the revenues a lot more as the basis of pricing an accounting practice acquisition.
Earnouts are a frequent element of the CPA practice purchase deal structure. This is especially so for firms that tend to rely on tax preparation as the main source of income.
A typical hold-back period is one year but can be shorter for accounting firms with substantial value-added services to help smooth out the hectic tax preparation season – and the practice’s income stream.
Example – CPA practice value estimation using multiples
Consider a practice generating $500,000 in annual client billings. A reasonable current valuation multiple is 1 times the revenues. This gives us the business market value for the practice of $500,000.
By convention, the value estimate includes the practice tangible assets, goodwill and other valuable intangibles such as the client lists. Liquid assets and practice owned real estate are extra.
Other methods for CPA practice appraisal
If you are handling the valuation of a small accounting practice, consider the Multiple of Discretionary Earnings business valuation method. A well-known variant of the direct capitalization valuation methods under the income approach, this technique is an excellent way to value a private accounting firm based on its earning power and a number of key financial and operational performance factors.
Business goodwill can be a large portion of the overall CPA practice value. The Capitalized Excess Earnings valuation method is a proven way to determine the value of practice goodwill. Known as the Treasury method, it has been described in the Internal Revenue Service Ruling 59-60 and 68-609.
With the amount of debt accumulated by both the consumers and businesses in recent years, professional debt collection is a growing business.
Key industry stats
Classified under SIC code 7322, there are close to 7,780 collection agencies operating in the US alone. They generate over $11.99B in annual revenues.
According to the US Bureau of Labor Statistics, over 121,000 debt collectors were employed in 2008 and the industry employment growth is likely to continue until at least 2014.
The industry is highly fragmented with the average collection agency making $1,700,000 in annual gross revenues and employing 16 collectors plus support staff.
Main business value drivers for collection agencies
Successful professional debt collection services get their business from a variety of clients that refer past due accounts for recovery. Effective firms focus on specific industries and achieve collection rates in excess of 10%.
While there are a number of factors that make for a successful business in this industry, some do stand out as the key business value drivers:
- Client concentration. A diverse client base is essential for smooth business cash flow. This, in turn, contributes to higher business value.
- Employee turnover. Work in a collection agency is stressfull and requires considerable skill. Training and retaining effective employees is an important factor that contributes to higher business valuations.
- Business practices that comply with legal requirements. Both the Federal Trade Commission and state governments regulate debt collection practices. Strict compliance is important to avoid severe penalties. Actual or pending legal actions can reduce the value of a collection agency considerably.
- State of the art communication systems. Efficient debt collection requires specialized phone systems and data processing equipment. This may be capital intensive and exert downward pressure on the business cash flow.
Valuation multiples for collection agencies.
Companies in this industry are driven by cash flow. Hence, you can value an agency using the cash flow based valuation multiples:
Other business valuation methods for collection companies
If you are valuing a smaller agency, consider doing it directly on its cash flow using the Multiple of Discretionary Earnings business valuation method. Importantly, the method also lets you assess such important value drivers as client and market concentration, quality of staff and management, and stability of earnings.
Valuing a Business as Multiple of its Earnings
Established collection agencies with long-term client relationships can build significant business goodwill as part of the overall company value. In this situation, you can take advantage of the Capitalized Excess Earnings method – an excellent way to determine the value of business goodwill.
This may be an essential step toward allocating the business purchase price in a tax-advantaged manner, setting up an earnout agreement with the outgoing ownership or a departing partner.
Valuation of Business Goodwill
I think you will agree – we are seeing the most unprecedented changes in the economic environment in recent history. And unlike the earlier downturns, the effect is felt across all industry sectors and by most businesses, large or small.
Business people are rightly concerned to ask: how does this affect my business value? Importantly, what are the best ways to determine the business value in a bad economy?
Three ways to value a business – in any economy
Let’s consider the options. There are three ways, known as business valuation approaches, that you can use to value a business:
- Market – by comparison to recent sales of similar businesses.
- Income – determing the business value based on the income outlook and company risk.
- Asset – based on the costs of business assets and liabilities.
Market business valuation methods
If you need a defensible business valuation in a changing market – consult the market directly. For private companies, the most compelling valuation method is to compare against the recent sales of similar private businesses.
When the economic outlook is cloudy, such market comparisons offer the sanity check of business value – based on the market-wide perception of earnings prospects and risk by your peers – the business people brave enough to buy, sell or merge small businesses!
This business valuation method is so important that is has a formal name in the professional business appraisal community: Comparative Transaction Method.
See how to determine the business value based on its gross revenues, net sales, profits, cash flow and assets. Direct comparison to similar private businesses that sold recently.
See Example »
Income business valuation methods
When market uncertainty is high, you need to review your business earnings forecast and re-assess the risk going forward. This is precisely what you can do using the Discounted Cash Flow business valuation method. Detailed business risk assessment lets you incorporate such important elements as the business size, industry segment and company specific risk.
How accurate your business valuation result is depends on the quality of your income projections and business risk assessment.
It is a good idea to run a few what-if scenarios – each using a different possible outcome. A worst case – best case analysis is typical. Your business value can then be calculated either as a range or a single number equal to the average of the two valuation results.
You can also use direct capitalization methods such as the Multiple of Discretionary Earnings to value a business. Make sure, however, that your earnings basis reflects the economic reality. The method allows you to assess such key risk factors as stability of business earnings, competitive position, market and product concentration.
Asset business valuation methods
The Asset Accumulation method, while useful for purchase price allocation among the various business assets, is difficult to apply in a tough economy. The reason is that appraising the value of individual business assets and liabilities may be difficult.
A better business valuation method is Capitalized Excess Earnings. Using this method you can determine the value of business goodwill and the total business value – by accounting for the business assets, while keeping a close eye on its earnings and growth outlook.
Methods for Small Business Valuation