How to calculate the value factor weights for multiple of discretionary earnings valuation method

One of the best known methods in private company valuation, the multiple of discretionary earnings technique, requires that you assess the firm across a number of value factors. You score the company on how well it does in terms of earnings growth, whether its industry sector has good prospects, how well it diversifies its products and services, how strong the management team is and so on.

This makes valuing a company very intuitive and easy to explain even to business people with little knowledge of business appraisal.

Assess key business value drivers

Once you have assessed the value factors for the business, the multiple of discretionary earnings method calculates an earnings multiplier that is used, along with your financial performance inputs, to calculate the value of the company.

How important is each business value driver?

But how is this multiplier calculated from those value factor selections you have made? Each factor is assigned a weight based on how important it is compared to other factors in creating business value. This importance is best assessed by studying what business people and investors think about each factor.

Is business earnings growth more important than customer concentration? Just how important is business premises location compared to its competitive position in the market? What is the contribution of a skilled staff or management team to building a strong, valuable company?

Earnings multiplier – each value driver contributes based on its importance

Each and every factor contributes to the overall value of the company. How much? You can get some clues from the market place. Let’s say you need to assess the importance weights for each of the 14 value factors such as those used by ValuAdder business valuation software. You collect data on 14 business sales, with known selling prices and seller’s discretionary earnings (SDE) for each company.

Business valuation – scoring businesses across all value factors

This gives you the actual earnings multiplier for each business sale. Let’s assume that you have also obtained business valuations for each firm in which the appraiser has scored the company across each of the 14 value factors.

Now you know some pretty important facts:

• Selling prices for each business
• Earnings basis (SDE) used to value the company
• Earnings multiplier, being the ratio of the selling price divided by SDE
• Numerical value for each of the 14 value factors assigned by the appraiser

Now you can calculate just how important each value factor is. For those of you mathematically minded, you have a system of 14 linear equations with 14 unknowns, namely the value factor weights.

Importance of business value factors – the math

In formal matrix form, the equations are:

A x W = M

where A is the assigned value factor selections made by the appraisers. In our example, this matrix has 14 rows and 14 columns of numbers. M is the earnings multiples calculated from the business selling prices divided by the earnings (SDE) for each company. This is a vector of 14 numbers.

From this equation you can easily calculate the 14 factor weights in the W vector. This gives you the answer as to how sensitive the multiple of discretionary earnings valuation method is to each of the value factors.

You can easily extend this procedure to more value factors than 14. You can also focus on gathering the business valuation statistics on an industry sector of interest, across different company sizes or in specific time periods and other valuation scenarios you may be interested in.

As new data on business values becomes available, you may consider exploring if the market indicates a change in importance for each and every value factor. You can update your weights by running a number of these calculations and averaging the results or to establish a trend indicated by market evidence.

Business valuation and cash flow forecasts

In business, cash is king. It stands to reason that the primary function of a business is to generate desired returns for its owners. Unsuprisingly, business value is defined by its earning capacity. The greater the returns, given an acceptable level of risk, the higher the business value.

No other business valuation method captures this idea better than the discounted cash flow technique. To use the method, you provide a cash flow forecast over some period of time in the future. The business risk is represented by the discount rate. Given that information, you can calculate what the company is worth today.

It should come as no surprise that your business value depends upon the cash flow forecast. While cash flow projection models abound, a simple way to start for a stable company is to look at the historic income trends.

This is a reasonable plan if you expect the business to continue running much the same as in the recent past. The model that fits this description is called linear regression. Essentially, you predict the business income and expenses based on their history. The math of the linear regression model combines the historic information as data points on a graph and draws a straight line into the future.

This works fairly well if you do not anticipate major changes in the business. You expect the customers to remain loyal and continue buying the company’s products. The prices should track their historic trajectory. You expect the suppliers to continue operating within existing contracts without sudden price hikes. Key expenses such as labor, energy, rental, and shipping costs should stay under control.

But what if you expect changes that affect the company’s prospects in the near future? The historic trends may no longer be a reliable guide. As a result, your discounted cash flow valuation may well produce misleading results. The problem is not with the method, it is your assumptions about business earnings and risk that may be out of line.

Consider a business buyer who is looking to purchase a business that has been losing money recently. The buyer may feel the company has potential that is not being realized under the current ownership. This makes the company an attractive acquisition target.

The buyer may need to make some changes to the business to tap the potential. This calls for a fresh earnings forecast that translates these changes into actual financial returns. Note that the business as usual paradigm does not apply here. The whole point is that the company turns a new page in order to achieve success.

The buyer’s cash flow forecast model departs from historic trends and represents a positive change expected following the business sale. Careful planning and review are key to provide the buyer with the justification of the business purchase and correct valuation.

In each situation you face, you can depend upon the discounted cash flow method to produce a precise business value result. The key challenge is coming up with the realistic assumptions and reliable cash flow forecast. If there is one situation where the old adage of ‘garbage in, garbage out’ rings true, this is it.