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:
- Business value divided by its net cash flow
- Business value to free cash flow
- Business value to seller’s discretionary cash flow (SDCF)
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.