Earnings are key to valuation
The most common method used to determine a fair sale price for a business is calculating a multiple of EBITDA (earnings before interest, taxes, depreciation and amortization), which is a measure of a company’s ability to generate operating earnings.
The multiples vary by industry and could be in the range of three to six times EBITDA for a small to medium sized business, depending on market conditions. Many other factors can influence which multiple is used, including goodwill, intellectual property and the company’s location.
After arriving at the EBITDA based figure, a professional business valuator typically seeks to confirm it by applying other valuation approaches—first, calculating the value of the company’s tangible and intangible assets and, second, checking what comparable businesses sold for.
How is a company valued?
Professional valuators typically use a mix of three methods to confirm the value of a business.
- Income-based approach—calculating a multiple of EBITDA
- Assets-based approach—calculating the value of tangible and intangible assets
- Market-based approach—checking what comparable companies sold for
Part science, part art
If the three valuation approaches yield different numbers, the valuator investigates why and may adjust the EBITDA multiple, if appropriate. This requires a lot of judgement and estimates.
A business may also be more valuable in pieces than as a whole. For example, you may find the target company’s real estate holdings more attractive as an asset than the entire business.
Differing expectations can cause conflict
Complicating matters is the fact that many entrepreneurs have an unrealistic idea of how much their company is worth.
This means you, as a potential buyer, may have a different value in mind than the company’s owner. That can cause conflict and derail a potential acquisition.
Because of the complexity and stakes, it can be very helpful for both sides to hire a professional valuator to set a fair price for the company. (It can also be helpful to consult a tax expert, who can explain how the various valuation options impact your tax liability in the purchase.)
An outside valuation may also help you identify weaknesses in the finances of the acquisition target and show you ways to maximize its value after the transaction goes through.
Finally, keep in mind that the price you finally settle on may differ from the appraised market value and can be affected by unexpected factors. For example, you may decide to pay a premium for the business because it’s a good fit with your existing company’s culture or because of competing bids.