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.
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.
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?
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.
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.
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.
See how to value a business based on its discretionary earnings (SDE) and a set of value factors. Each factor contributes to business value in proportion to its relative importance. Actual business values and assessment of value factors can help you determine just how important each value factor is.