Valuation multiples and guideline public company method

Estimation of business value by comparison to similar companies in your industry sector is at the heart of the market approach. Many business appraisal experts and business people believe that business value can only be established by market participants – buyers and sellers of business ownership interests.

Valuation multiples are the tools you have to do such comparisons. The multiples are ratios that relate business value to some measure of the company’s financial performance. Typical valuation multiples used in business appraisals are:

• Enterprise value (EV) to gross revenue or net sales.
• EV to gross profit.
• EV to net income.
• EV to EBIT or EBITDA.
• EV to hard assets or total business assets.
• EV to owners’ equity.

Sources of comparable business data for valuation multiples

If you are valuing a private company, there are two central methods under the market approach you can use:

• Comparative private company transactions method.
• Guideline publicly traded company method.

While comparison to private business sales seems compelling, gathering reliable, consistent transaction data is a challenge. There are a couple of reasons for this.

Private businesses are not required to comply with major financial reporting standards such as GAAP or IFRS. Private company owners typically manage their firms to minimize taxes. This tends to obscure the firm’s actual earning power. Without knowing more about each private company selected for comparison, there is no way of knowing if, say, net income or EBITDA can be calculated with any degree of accuracy.

In addition, private company transactions are not required to be disclosed to the public. As a result, a very large number of such deals go unreported. For the purposes of calculating reliable valuation multiples for your comparison these important transactions do not exist.

Advantages of guideline public company method

In contrast, you have plenty of data on similar public companies in your industry sector. First, every publicly traded firm, regardless of its size, is required to make regular filings with the government. In the US, such filings are made with the Securities and Exchange Commission (SEC) and wind up in its EDGAR database.

Equally important, all financial disclosure documents on public companies must comply with accepted reporting standards, such as GAAP. So when you calculate your valuation multiples from such data, your calculations produce consistent, verifiable results.

Discount for lack of marketability (DLOM)

One key difference between the public and private companies is marketability of business ownership interests. To use the guideline public company data for private firm valuation, you need to apply what is known as discount for lack marketability.

For example, let’s assume that an EV to net sales valuation multiple you calculated by analyzing small capitalization public companies is 1.5. Applying a DLOM of 40% to this number gives you a private company valuation multiple of 0.9.

Calculating valuation multiples from guideline public companies: the procedure

To sum up, you can calculate a set of highly relevant valuation multiples for a private company valuation as follows:

Step 1. Identify the industry sector your firm operates in

Come up with the SIC and NAICS codes.

Step 2. Visit EDGAR database

Locate a number of small or mid-size guideline companies similar to yours. In just about every sector there are plenty of small cap public companies that you can include in your comparison data set.

Step 3. Calculate guideline valuation multiples

Decide upon the financial measures for your comparison, such as revenue, EBITDA or business assets. Then calculate the valuation multiples using the guideline public company data you have assembled.

Step 4. Adjust valuation multiples for DLOM

This is important to make your valuation multiples suitable for private company valuation. The typical sources of data for DLOM are the restricted stock and pre-IPO transaction prices compared to sales of fully marketable stock in the same companies.

Step 5. Calculate your company’s value estimates

You can now assess the business value using the valuation multiples developed. Take a look at a typical format for doing so.

Business valuation of pet stores

Do you need to value a retail pet store? Here are some industry statistics to consider first:

Pet stores are classified under the retail industry SIC code 5999 and NAICS 453910. Pet retail establishments make up a large portion of the miscellaneous retail industry. In the US there are just under 169,000 such operations.

This retail sector creates a total of $58.8B in annual revenues, and employs some 732,900 people. However, a typical pet store is small business: producing an average of $400,000 in sales per year with 4 staff.

In fact, 97.7% of pet retail businesses have 24 or fewer employees. Together these small, local businesses generate about 68.7% of the industry total annual revenues.

Well-established, successful pet retail businesses develop loyal customer following. The result is highly stable earnings year after year. Such cash cow operations are attractive acquisition targets.

Hence, an excellent way to estimate the fair market value of your pet retail store is to study the recent sales of similar businesses.

Pet store valuation using multiples

You can choose a number of valuation multiples for your business valuation. The multiples are ratios that relate the selling prices to some measure of sold companies’ financial performance. Here are the typical valuation multiples used in pet store appraisals:

• Price to net annual sales
• Price to gross profit
• Price to net income
• Price to EBIT and EBITDA
• Price to seller’s discretionary earnings
• Price to total practice assets
• Price to owners’ equity

Consider using several of such valuation multiples for increase the accuracy of your business valuation.

Each multiple gives you a business value estimate that may differ depending on how your pet store compares to its industry peers. The result can be a range of values, from low to high. Alternatively, you can calculate an average of all the business value estimates together.

Example: pet store valuation using multiples

To illustrate, let’s take a typical privately owned pet supplies store with the following financial details:

• Annual net sales: $400,000
• Gross profit: $180,250
• Net income: $30,000
• EBITDA: $32,750
• Discretionary earnings (SDE): $85,000
• Inventory: $55,000
• Furniture, fixtures and equipment assets valued at: $40,000

We next select a set of reasonable valuation multiples and apply them to the financial figures above. The practice value results are then:

Note the result spread. This depends on how our example pet store compares to its peers across the financial performance parameters.

Other pet store valuation methods

As with other types of businesses, a properly done business valuation should include several business valuation methods.

Established pet store businesses can build up significant business goodwill. The Capitalized Excess Earnings valuation method is a good choice when valuing such companies.

Direct capitalization methods, especially the Multiple of Discretionary Earnings valuation method are an excellent choice for valuation of privately owned pet stores. This method offers you a very systematic yet intuitive way to calculate the business value based on its earnings and a set of key financial and operational performance factors.