If you ever valued a private company, you probably ran across the venerable Multiple of Discretionary Earnings business valuation method. This technique is perhaps the most common in valuing owner-operator managed businesses. Its appeal is simplicity and excellent coverage of value factors that demonstrate what creates business value and how you can improve operations in order to increase business worth.
As this example shows, the Multiple of Discretionary Earnings method lets you assess the company across a set of key financial and operational performance factors. You score the business on each factor, input a set of financial figures, and the method calculates both the earnings multiple and the overall business value.
Better run, more profitable businesses generally command higher selling prices in the market. The Multiple of Discretionary Earnings method captures this trend very well. For example, you may ask the questions:
- How much is business value affected by the stability of business earnings over time?
- Is the quality of management team important to business value?
- What is the effect of customer concentration on the company’s valuation?
- Is a business with efficient, well documented business practices more valuable?
The method lets you answer all these questions and more. Importantly, you can spot weaknesses and opportunities to see how much your business value would increase if you made improvements. A great way to make strategic decisions that translate into a greater business value!
But one question remains. Just how high do the earnings multiples get in the ‘real world’? Is there a reasonable range of Seller’s Discretionary Earnings multiples a private business can actually sell for?
This brings us to the area of statistical data analysis. One way you can answer this important question is by studying comparable business sales. You can relate the actual business selling prices to earnings and calculate the earnings multiples observed in the market place.
Conventional wisdom tells us that private businesses tend to sell for somewhere between 0.1 and 4 times the SDE (Seller’s Discretionary Earnings). However, if you analyze the business sales data, you will discover that the range is quite a bit wider.
True enough, close to 90% of private businesses do sell for earnings multiples in the range of 0.1 to 4. But the upper 10% defy this trend.
Indeed, the top 10% of private businesses can price above 50 times the SDE. If you visualize the earnings multiple trend versus the percentile of sold businesses, the graph starts out smoothly, reaching the multiple of 4 for a 90% business sale percentile. Thereafter, the graph trends sharply up, reaching beyond 50 times the SDE for the top 1% of all businesses sold.
This is perhaps an interesting demonstration of the 10% – 90% statistical adage. The highest 90% of the earnings multiples are commanded by the top 10% of all businesses.
What are the reasons for such dramatic differences in selling multiples? Here are some we have noted:
- Successful businesses at the top of their game command much higher valuation multiples than their peers.
- The best businesses attract the bulk of business buyers and investors who bid up the selling prices competitively.
- The top performing companies have the best earnings growth prospects, which directly affect their value.
One statistical reason often overlooked is that in some industries business sales are priced on other measures of financial performance or condition. For example, high technology companies are often acquired based on their assets, especially intellectual property; or their gross revenues.
The earnings multiples could be very high if these companies have not yet been optimized for peak profitability. The acquiring entity, typically a large corporation, may have a very different vision for profitability using its own economies of scale, market access, and capital to grow the young company further.More on Valuation