Do Your Own Business Valuation – Part 7: Income-Based Valuation Methods
There are 3 approaches to valuing a business – market, income and asset. This article covers the income approach.
Types of Earnings
There are many types of earnings used in business valuation methods. Here are the most common ones with brief explanations. It is extremely important to use the correct type of earnings for the selected method.
Earnings before taxes (pre-tax earnings) – Many valuation methods use pre-tax earnings.
Earnings before interest, taxes, depreciation & amortization (EBITDA) - EBITDA is a close approximation of cash flow because it adds back the non-cash expenses of depreciation and amortization. A multiple of EBITDA is a common valuation formula.
Cash flow - There are many types of cash flow. Cash flow is considered a more pure form of earnings and is often preferred for valuations.
Seller’s discretionary earnings (SDE) – For owner-operated companies SDE is the preferred earnings for valuation because it represents the total earnings available to the owner. SDE starts with EBITDA then adds back owner compensation and benefits.
As described in Part 5 of this series, each type of earnings must be adjusted to more accurately reflect the true earning capacity of the company for things like related party transactions, and non-operating and unusual items.
For a company that has fluctuating or relatively stable earnings, a three to five year average will best reflect the earning capacity of the company. A weighted average can be used to give greater weight to specific years. If earnings are consistently growing or falling, the results from the most recent year may be a better choice.
The Multiple of Seller’s Discretionary Earnings (SDE)
This method applies a multiple to the SDE of a company to determine its value. The multiple can come from several sources. The most preferable source is data from the actual sales of private companies described in Part 6. Another source is from industry rules of thumb described in Part 8. The source of last resort is an evaluation of the specific risks related to your company as described in Part 4.
This method is best suited to a company where the salary and perquisites of an owner represent a significant portion of the total benefits generated by the company, and the owner typically runs the day-to-day operations. Buyers and sellers of small companies tend to think in terms of their potential personal compensation rather than business profits. They look at the total discretionary earnings to see if it is sufficient to carry the debt structure necessary to buy and operate the company, and provide them with adequate compensation.
Capitalized Cash Flow
The capitalized cash flow (CCF) method converts the cash flow of a company into a value using a capitalization rate. The cash flow is divided by the capitalization rate. The capitalization rate reflects the expected rate of return as described in Part 4.
This method works well when a company has a history of stable, growing, or significant cash flow; and minimal tangible assets. It reflects the value of a company from the perspective of an investor or absentee owner.
Because earning capacity is the primary driver of business value, income-based valuation methods are the most commonly used ones. They are most appropriate for companies with established earnings histories. Underperforming or unprofitable companies should consider using another valuation approach.