Valuation multiples that relate business value to some measure of its earnings are among the most typical tools used in business appraisals. There are essentially two types of such valuation multiples:
- economic multiples that relate business value to its cash flow
- accounting multiples that use any of the well known business profitability metrics.
Business appraisers tend to prefer the economic valuation multiples. This is because the business income producing capacity demonstrated by its cash flow is deemed to be the true reflection of its worth. In fact, the net cash flow captures all three important ways a business generates or uses money:
- income from operating activities
- cash flow arising from financing activities such as raising debt and equity capital
- cash flow produced or used by investment activities such as buying new assets or selling off old ones.
Earnings valuation multiples based on cash flow
Here are the cash flow based valuation multiples seen most often in professionally done business valuations:
The SDCF, also known as seller’s discretionary earnings (SDE), is the preferred measure of earnings when valuing small owner-operator managed companies. For larger firms, the net cash flow (NCF) is the more typical choice.
Many business people and professionals are familiar with various profitability measures used by accountants. Just about everyone has their favorite earnings multiple in mind when valuing a business. Unfortunately, the accounting valuation multiples tend to be less accurate when calculating business value.
Accounting earnings valuation multiples
Here is a list of typical earnings valuation multiples from this category:
- Business value divided by EBITDA
- Business value to EBIT
- Business value to net income
- Business value to gross profit.
You may find it surprising that application of different earnings valuation multiples produces results that can be wide apart. When in doubt, opt for the valuation multiples based on cash flow. Such earnings bases as net cash flow are usually a far more accurate picture of the business earning power and, therefore, its true worth.
Valuation Multiples in Business Appraisal
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ValuAdder Business Valuation Software
S corporations are so-called pass through entities. The company itself pays no income taxes. Instead, the shareholders pick up their share of business earnings and put them on their own tax returns. This is big savings compared to the double taxation common with the C corporations.
Pre-tax or after-tax earnings for your business valuation?
When valuing a private company formed as an S corporation, the key question is whether to use the pre-tax or after-tax earnings as your basis. Business appraisers differ in their approach.
One scenario – business valuation for acquisition
An argument in favor of using after-tax earnings in your business valuation is that it puts the S corporation on an equal footing with companies paying income tax. Successful S corporations are often bought by larger competitors organized as C corporations. In this case using a reasonable corporate tax rate makes sense. Note that imputing 35% or higher income tax to the company will certainly affect your business valuation result.
Another case – valuation for buy-sell agreements and partner buyout
A different scenario is a partner buyout valuation. The block of shares is likely to be bought by the remaining business owners who will pay only individual taxes. In this case valuing the company on the pre-tax earnings basis is the right thing to do.
Since S corporations tend to be smaller and usually riskier than their C corporation counterparts, the discount rates tend to run higher. This has the effect of reducing business value even if the company is valued on the higher pre-tax earnings basis.
Private Corporation Business Valuation
Are you considering valuation of a commercial building contractor firm? Check out these industry statistics:
There are some 38,000 commercial and institutional construction companies, classified under the SIC code 1541 and NAICS 236220. These construction firms generate a combined $372.5B in annual revenues. The industry sector employs an impressive 654,178 of professional and administrative staff, down 6% from 2002. During the construction boom of 2002 – 2007 the value of construction work done per employee in the sector grew 61%.
The average commercial building construction firm does $9.791M in annual sales with a staff of just over 17. The average revenue per employee in this construction industry sector is $56,201.
Building contractor business valuation
Commercial construction companies with a solid track record of profits and strong customer following are highly desirable acquisition targets. This is good news if you need to value an established contractor business.
You can use the recent business selling prices in relation to the sold companies financial performance numbers. This gives you valuation multiples to use in calculating your company’s value.
For privately owned commercial building contractors, the most typical valuation multiples are these:
Example: Business valuation of commercial building construction firms
Let’s illustrate the concept by valuing a typical contractor company with these financial figures:
- Revenue: $9,791,000
- SDCF: $1,700,000
- Furniture, fixtures and equipment (FF&E) assets: $300,000
Next, we pick the valuation multiples calculated from recent sales of businesses in the sector and apply them to the financials above to calculate the business value:
|Business value to gross revenues
|Business value to SDCF
|Business value to FF&E assets
|Average Business Value
Another way to report your business valuation result is to indicate a range of values, from low to high. In this case the company value will likely fall somewhere between $3,165,555 and $3,456,461.
Commercial construction contractor valuation by capitalization methods
Building contractor companies also can be valued by direct capitalization methods under the income approach. Instead of comparing your business to other firms, your valuation focuses directly on your company’s earnings capacity and risk.
A common method of valuing privately owned building contractors is the multiple of discretionary earnings technique. This valuation method lets you determine business value by capitalizing its earnings. The capitalization rate is built up based on your assessment of a number of key financial and operational performance factors.
Current selling prices of similar construction firms offer you market proof of business value. You can value businesses in this industry based on their gross revenues, net sales, profits, EBITDA, cash flow and assets.
See Example »