A business valuation is an in-depth calculation used to estimate the economic value of an owner’s interest in a business. It is important for a business owner to know the true fair market value of their business. There are multiple ways a business valuation can be concluded. A common methodology used is called the multiple of earnings (MOE) valuation. Learn about the multiple of earnings valuation method from the industry experts at Investment Business Brokers.
Multiple of Earnings Valuation
What is the Multiple of Earnings Valuation?
The multiple of earnings is a valuation method whereby the value of a company is expressed through the use of a multiple applied to the company’s earnings. For example, a company that has earnings of $1 million dollars with a multiple of 6x will be valued at $6 million. The two key drivers of this valuation method are earnings and the multiple so it is important to determine these figures accurately. For instance, if we use the example above but only use a multiple of 3x then the valuation will be $3 million, half the original price.
Defining Your Earnings
There are many different terms that get thrown around to define earnings: net income, adjusted income, bottom line, cash flow, EBITDA, discretionary earnings, etc. It’s important to distinguish what these different terms mean to make sure you apply your multiple to the correct number.
Net Income – sales minus cost of goods sold, general expenses, taxes and interest. It is found at the bottom line of the income statement.
EBITDA – stands for Earnings Before Interest, Taxes, Depreciation and Amortization and is a metric used to evaluation a company’s operating performance. It is commonly known as cash flow.
Discretionary Earnings – net income plus any one-time or non-recurring expenses for the business, plus any personal expenses the owner runs on the business profit and loss. Also known as cash flow or adjusted income.
Now, which one of these do I use to define the earnings of my company?
Net income is not used because it considers certain non-cash and one-time expenses. Which if added back to the profits, can substantially increase the true fair value of the company. To better illustrate, imagine two identical companies:
Company A has a loan and makes interest payments of $20,000 every year. While Company B does not have a loan. Company A has a net income of $100,000 lower because of interest payments. Company B has a net income of $120,000.
When you apply a multiple of say 3x, company A has a valuation of $300,000 and company B has a valuation of $360,000. But remember that both companies are identical. This is why discretionary earnings are important. If we value a business based on net income, we would get inaccurate valuations.
Discretionary earnings and EBITDA are the correct financial metrics to use as earnings in the MOE calculation. As a standard practice, industry experts generally use discretionary earnings for business in the $1 – 10 million range and EBITDA for $10 million and up.
Establishing a Multiple
The other important number to get right in the multiple of earnings valuation, or MOE valuation, is the multiple. Businesses in the $1 – 10 million range tend to use a 2 – 4x multiplier. Businesses larger than $10 million can have multiples that can at times reach as high as 8 – 12x EBITDA. There are many factors that weigh into whether the multiple should be higher or lower for a given business.
Common Factors to Think About When Establishing a Multiple:
Revenue Trend – Which direction are your revenues trending? If your business is showing year-over-year growth in revenue, the business will receive a higher multiple. If revenues are decreasing, the multiple will be reduced.
Industry – Multiples are specific to industries. Typically, small service-based businesses sell at a 3x multiple whereas as Software as a Service (Saas) business can sell at a 15x multiple.
Company Age – How many years has the company been operating? An established business with strong customer relationships and a strong brand name takes time to build. This creates stability and increases the multiple.
Owner Involvement – A buyer will take into consideration the amount of time that has to be committed to operating the day-to-day business. The multiple is increased when the owner shows low levels of involvement and vice versa.
Financeable – Can a buyer use debt to help pay for the business? If the answer is no, then the multiple will decrease due to the more upfront cash that the buyer has to use to make the acquisition.
Review of the Multiple of Earnings Valuation
The reason this valuation method is popular is due to its simplicity and accuracy. Any business owner can easily estimate the value of their business by doing a little homework to figure out precise earnings and multiple.
Advantages of the Multiple of Earnings Valuation
Quick Calculation: Some basic algebra can get you close to your true fair market value. Other valuation methods take a lengthy analysis to figure out.
Widely Accepted: Most buyers will use this methodology to agree upon a price for the business. There is not a lot of room for buyers to negotiate the price as this technique usually provides the lowest value compared to other methods. Additionally, if you are raising capital, investors and lenders will use the MOE to determine a valuation.
Disadvantages of the Multiple of Earnings Valuation
No Growth: The MOE does not consider any future performance of the company. If revenue is projected to increase in the coming years due to company growth, that value is not included in this valuation.
Low-end Value: The MOE valuation is known to give a business the lowest valuation due to the heavy weight applied to the historic performance of the company.
Multiple of Earnings Valuation: Investment Business Brokers Can Help
It is always in your best interest to consult an industry professional such as a valuation analyst, business broker or M&A advisor to ensure you are accurately pricing your business. If you need a business broker in Texas, Investment Business Brokers gets deals done.
If you have any other questions about how to value your business or determine the correct earnings and multiple to use, contact us and we are happy to share our knowledge with you.
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