Rules of Thumb to Value a Business

Quite often, we are asked during presentations which ‘multiple’ is the right one with which to assess the value of a business. Without doubt, most business owners then volunteer that the EBITDA multiple (Earnings Before Interest, Tax, Depreciation, Amortization) is the best single criteria.  However, only relying on earnings can be short sighted.

EBITDA, by its definition removes the elements of financing and accounting decisions by adding back interest, depreciation and amortization and thus, can be used to compare the profitability between companies and industries. Further, it can analyze industry trends over time.

However, EBITDA is not always a good measurement for cash flow– with cash flow being the most vital component for small and midsized businesses to survive. For that matter Operating Cash Flow is a much better criterion to assess cash flow since it includes the changes in working capital– most significantly A/R, inventory and A/P.

For example, relying only on EBITDA as value measurement, an analysis could easily neglect to find an inventory built-up due to poor product design, resulting in an increased need for financing or future margin erosion due to required discounting. Additionally, the need for additional working capital as accounts receivable increase; can cause a significant drain on cash, particularly in seasonal businesses.

Generally, there is no single “rule of thumb” by which to assess the value of a business. Indeed, we caution not to use very often heard ratios such as 50% of annual sales for liquor stores, 1.1 times revenue for accounting firms, 60% of revenue for dental practices or 3 times for software companies, just to mention a few examples.

As a matter of fact, most professional valuation associations do not recognize rules of thumb as legitimate valuation methodologies. Large databases of market comparables, such as Pratt’s Stats, BIZCOMPS or the one of our firm provide a basis for a much more qualified approach.

Typically, a professional valuation is based on numerous criteria, such as an Asset Based Approach, Income Based Approach and Market Based Approach, whereas each approach has several sub-criteria to establish a value. The valuation firms we work with usually take at least eight different key components into account for a value assessment. Then weighting each of the methodologies based on their respective merit to arrive at a Fair Market Value for the business.

Only such a detailed approach will provide the seller not only with a Fair Market Value for his own decision making, but said approach also establishes credibility for the asking price with a potential buyer and with lending institutions funding the acquisition for the buyer. Omitting such a professional valuation will ultimately hurt a seller in more than one way.

Achim Neumann is president of
A.Neumann & Associates, LLC
Atlantic Highlands,
an affiliate of BBN, Dallas, Texas, with 450 offices nationwide.

Visit the firm at www.neumannassociates.com
or call 732-872-6777

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