Small business valuation multiples are a quick and useful way to determine the value of a business. The formal name for this method of valuation is the ‘Future Maintainable Earnings’ method. Essentially you determine the level of earnings that the business can sustain into the future. For ease of calculation, let’s say that you operate a business and it can consistently generate profit after tax of say $100,000 per year. A common multiple may be around 2.0 for a small business. In this case, the value of the business is $100,000 x 2.0 = $200,000. As you can see once you know what a business’s recurring level of income it can become relatively easy to calculate the value of the business.
Normalising future maintainable earnings
Although this technique can be useful when it comes to calculating the value of a business, there are complications that you need to be mindful of. Firstly, let’s look at the estimate of future maintainable earnings. In the above example, we have used the profit after tax result of $100,000. However what happens if in calculating this profit level, the owner of the business has been working in the business and hasn’t drawn a salary or wage. If the business was sold then the new owner will need to employ someone to take on the role that the previous owner performed. We need to adjust the level of maintainable earnings to account for this adjustment. If a manager could be employed on a salary of $40,000 per year and this was considered reasonable. It may be appropriate to adjust the level of future maintainable earnings down from $100,000 to $60,000 to account for the salary that should be included in this amount. The technique of adjusting the level of future maintainable earnings is called normalising the earnings. Assuming the same valuations multiple, the value of the business is calculated as $60,000 x 2.0 = $120,000. The value of the business has now decreased by 40% with a single adjustment. Hopefully you can see that whilst this valuation methodology is relatively easy to apply in one sense. The rigorous application of this technique can become very important, particularly when you are financing the investment of the business, or for example if you require a valuation for a family law property settlement dispute, a difference of $80,000 in a valuation can impact on the property settlement that you may receive as part of your divorce or separation. In the above example, the owner’s salary and wages was excluded from the Profit and Loss Statement. Another common adjustment in a future maintainable earnings valuation is adjusting items of expenditure that are included in the Profit and Loss Statement but may relate to personal consumption. An example of this is that the owner may have a telecommunications account in the business name. On the account may be several mobile phone numbers. A number of these may relate to the owners partner and children. These individuals are using their mobile phones for personal purposes and not related to the business. In this example, let’s assume that the portion of the total phone bill that relates to personal consumption is $300 per month. Over 12 months, this translates to $3,600 of phone charges that do not relate to the business. This amount needs to be added back to the profit and loss statement. The adjusted future maintainable earnings amount is therefore $60,000 + $3,600 = $63,600. Assuming the same valuations multiple, it can be seen that the value of the business after this adjustment has been made is now worth $127,200. In a typical small business valuation, there are many thousands of transactions and as a result there are many opportunities to ‘normalise’ the earnings during a valuation. From the above two examples, I hope that you can appreciate some of the considerations that you need to make when valuing a business. It’s critical that you employ a business valuation expert who can investigate the financial statements of the small business.
Business valuation for Court purposes
If you require a small business to be valued as part of a family law or other court dispute, then we recommend that you use a professional who is prepared to submit the valuation report to the court and be cross examined on its contents. If you require a joint expert valuation report to be prepared, then we strongly recommend that a detailed and comprehensive report is prepared. In our experience, once a joint valuation report has been prepared, it can be difficult to then challenge the contents of the report or subsequently adjust the report. We therefore recommend that you obtain a report where the valuer is prepared to approach the valuation with an enquiring mind and to seek appropriate evidence for the key variables on which the valuation arises. In some circumstances, we also recommend that the business valuer use an alternative valuation technique such as a Discounted Cash Flow or other technique to confirm the valuation using a valuation multiple as described above. In the above examples, you can see that just two relatively simple adjustments caused the valuation to differ by a substantial amount. The investment in a quality valuation report will more than pay for itself. If you are looking for small business valuation multiples, you may find the Biz Exchange Survey results useful. A sample of results as at June 2011 can be seen below:
The above valuation multiples use broad industry classifications to provide average multiples. The data is useful however if you are considering a valuation, we recommend that more precise multiples are used. Clearly if you are valuing a law firm or say a child care centre, a sufficient number of these businesses are sold and the valuation multiples that you would achieve for these businesses can vary substantially.
Investigation and Due Diligence
As can be seen from this article, arriving at a normalised earnings amount can require a degree of investigation or due diligence. Many business owners or potential business owners are reluctant to spend money on investigating accountants or employing a forensic accountant. Typically potential owners are keen to save their money for purchasing inventory or investing in a fit out. Whilst we appreciate these considerations, we find that obtaining legal and accounting advice prior to buying or selling a business can result in a number of financial and other benefits and give the business a solid foundation on which future success can be built.
Business Valuation Expert
Andrew Firth is a director of Rushmore Group. He is a forensic accountant and expert business valuer. Andrew has conducted business valuations across a wide range of businesses and for different court jurisdictions. He is a member of the Institute of Chartered Accountants, and the ICAA Special Interest Group in Business Valuations. He has appeared as an Expert Witness in numerous jurisdictions.
To arrange an appointment to meet with Andrew, please call 1800 454 622 or email firstname.lastname@example.org.