Valuing your business as multiple of its earnings: key assumptions and adjustments
The Multiple of Discretionary Earnings is a classical example of direct capitalization methods under the Income Approach to business valuation.
Using this technique you can determine your business value as a capitalized multiple of business discretionary cash flow. The valuation multiplier used by the Multiple of Discretionary Earnings method is built up based on your evaluation of business financial and operational performance factors.
Importantly, your business valuation result is calculated as though the business were offered for sale.
Business asset sale assumptions
Small business sales are usually structured as asset transactions. In such situations the following assumptions are typical:
- Business assets are delivered free and clear to the buyer. The seller pays off all liabilities prior to the business sale close.
- The buyer gets all hard assets, including inventory, plus business goodwill.
- The seller usually retains cash, accounts receivable and any non-operating assets.
- Business owned real estate is appraised separately.
Your Multiple of Discretionary Earnings business valuation calculation requires that you make several adjustments that match this asset business sale scenario:
Net working capital adjustment
Net working capital adjustment accounts for the liquid capital needed to run the business. This includes cash on hand, accounts receivable, but excludes the short-term portion of long term debt. The inventory is also excluded to avoid double counting – since the method’s valuation multiplier has the inventory value built in.
Adjustment for value of non-operating business assets
You need to specify the value of non-operating assets. These assets do not currently contribute to business income, hence their value is extra.
Value your business on a rented premises basis
Most small businesses lease their premises. If your business owns its property, it is common practice to adjust the income statements for a fair market rental expense. This affects your business cash flow and capitalized business value. You can then value the real estate separately as part of the deal.
Two business values: owners equity or total invested capital
If you need to determine the value of business owners’ equity, specify the long-term liabilities as well. Otherwise, your business appraisal is done based on the market value of invested capital – which includes both the equity and debt holders interests.
This is the business value the buyer gets in an asset sale.