One of the most useful business valuation methods under the income approach is the Multiple of Discretionary Earnings technique. Formally known as a direct capitalization valuation method, the Multiple of Discretionary Earnings lets you determine business value based on two key elements:
- Company’s discretionary earnings
- A set of financial and operational value factors
As with any capitalization method, the Multiple of Discretionary Earnings applies a cap rate to the business earnings to come up with a business value number. The difference is how this capitalization rate is calculated.
The approach taken by this method is to build up the cap rate based on your assessment of the business risk factors. Each factor affects your business valuation result to a different degree. Together, this business risk evaluation offers a very comprehensive yet intuitive framework for business valuation.
Here are the business valuation factors, along with a brief description of each:
Business earnings track record
Companies that generate stable, above industry average earnings are more valuable. The higher this valuation factor, the lower the risk that business earnings can decline unexpectedly. The net effect is a greater business value.
Industry growth prospects
Firms operating in rapidly growing industry sectors are more valuable. These days companies in the health services, energy and education are likely to face favorable growth prospects because the demand for these types of products and services is growing.
Business growth prospects
Regardless of the industry your firm operates in, business value depends largely on the company’s earnings growth outlook. This valuation factor is highest for the companies with an outstanding earnings growth track record.
Ease of access to business financing
Financial capital is the lifeblood of successful businesses. Ability to attract and retain required financial resources is key to business success – and directly impacts what the company is worth.
Businesses that compete in the market segment dominated by a few large, well-funded competitors face tough times ahead. Your company is likely to be more valuable if it does most of its business in highly fragmented market sectors with many smaller competitors.
Location can make or break a business. Great customer access, well-designed premises that invite both new and repeat business tend to go with higher business values.
Most successful companies try to reduce dependence on a few large customers. Should any one customer be lost, the effect on business earnings is minimal. The more loyal customers a company has, the higher its value.
Product and service concentration
A diverse product and service mix is the hallmark of successful businesses. This helps companies overcome seasonal variations in demand as well as establish themselves as a one stop shop for many customers.
Much of business success and growth outlook depends on how well it can enter a number of markets. For example, firms with a regional presence are more valuable than local companies. This market diversification reduces business risk and adds to business value.
Business competitive advantages
Sustained competitive advantages such as great technology, exclusive distribution rights or highly loyal customer following are sure value creators for any business.
A business is more valuable if there is considerable demand for similar companies by business buyers.
Ease of operation
A turnkey operation is easier to acquire and, therefore, attracts more potential business buyers and investors. Given the increased demand, the company’s market value is likely to be higher.
Skill and knowledge of staff
Great companies succeed by attracting, training and retaining great people. Such workforce is one of the most valuable business assets.
Quality of the management team
Savvy business decisions that help the company grow are no accident. An experienced management team can steer the business through good times and bad and greatly increase its value.
Example: Business valuation as multiple of its earnings
This valuation method is both intuitive and powerful. Why? It lets you score a business across the key value drivers and come up with a rock solid business valuation result.