If you talk with professional business investors or business brokers, soon enough you will hear them mention business valuation ratios. Business appraisers refer to these tools as valuation multiples.
Basically, the ratios are a technique to estimate the value of a business based on comparable business sales. Such market-based valuation tools are very useful in a number of situations that call for a defensible, objective business appraisal:
- Business sale or purchase. Buyer and seller can justify their valuations based on the objective, empirical evidence.
- Legal disputes which often require that the fair market value of a business be determined. Again, objective market proof of business value is a great way to resolve disagreements.
- Tax issues such as gift, estate and income taxes. Tax authorities are very keen on checking the market data to verify the business appraisal results submitted by tax payers.
Typical ratios used in business valuation
Since no two businesses are the same, the actual business selling prices will differ from one transaction to another. Relating the selling prices to the business financial performance measures is the best way to develop reliable ratios for your business valuation.
As you can expect, the business income statement and balance sheet items are the usual choice of basis to calculate the business valuation ratios. Here are the most common ones:
- Business selling price to gross revenues or net sales
- Price to gross profit
- Price to net income
- Price to EBT, EBIT and EBITDA
- Price to seller’s discretionary cash flow or net cash flow
- Price to fixed business assets or total asset base
- Price to owners’ equity.
The accuracy of each business valuation ratio varies by industry, company size, and the time frame when the business sale comps have been selected. The best ratios are those showing the smallest spread of values, from low to high. This indicates that business people rely on some business valuation ratios more when pricing the actual business acquisitions.
Choosing the ratios for your business appraisal: best practice
One way to develop a highly defensible market-based assessment of your business value is to use several ratios or valuation multiples at once. Each will produce a result indicating what your company may be worth based on the specific financial performance measure.
You can then use these valuation results to come up with a solid estimate of business value. Let’s say that the lowest business value for your company as determined by the price to gross revenue valuation ratio is $1,000,000; the intermediate value based on the discretionary cash flow is $1,100,000; while the highest is $1,250,000 as indicated by the price to net income ratio.
You can conclude that the market value of the business will fall somewhere in the range established by these numbers, in this case $1,000,000 – $1,250,000.
On the other hand, the numbers can be averaged to give a single number for the business value: $1,116,667.
In fact, both the range and a single value number reporting is industry-standard for professional business appraisals.