The Art of Business Valuation’s, Managing Member, Gregory Caruso, was recently published in the May/June 2023 issue of The Value Examiner. Greg’s article, “Market Method for Valuing Small Businesses – Selecting the Multiplier,” focuses on how to select the multiplier when valuing a small business using the transactions market method in business valuation.
The market method works by comparing actual sales transaction data for companies that are comparable to the subject company. This method is not perfect, but for many small and micro businesses (typically less than $10 million in revenue) it is one of the best methods because, for most industries and SIC or NAICS codes, there is sufficient relevant data.
This and much more information on business valuation of small businesses with revenues under $10 million is available in his book, “The Art of Business Valuation6”, published by Wiley and available online including Amazon. https://amzn.to/3YmTC8T
Over the years, I have found too many business valuators try to apply methods appropriate for valuing large public companies such as Home Depot when they are valuing a local hardware store.
This is like trying to value your home by looking at a downtown office building. You could do it but, really, why would you?
The local hardware store, a very small or typical micro-business, requires different methods and tools than valuing large companies. The companies are not the same and the valuation methods should not be the same either. This problem is most evident in businesses with revenues under $10 million and even more so with businesses with revenues under $5 million. There are better ways available for valuing these smaller businesses. By the way, according to 2012 Census data (the latest available) over 95% of payroll businesses have revenues under $10 million.
This book may be the only business valuation book to really focus on valuing these smaller businesses. Certainly it is the most comprehensive. What you will get from the book is the ability to more accurately prepare or review business valuations of micro and small businesses with data that is really available both inside and outside the business.
In more detail this means you will have a clear understanding of how to apply the most appropriate methods for these very small businesses. While I strongly favor the market method I deal with the complexities of income methods including tax affecting, specific company premiums and more. In addition you will learn methods to address the accounting and cash flow normalization issues so common in small business valuation. Finally, professional judgment and common sense is stressed throughout.
The best a business valuator can do is issue an “Opinion” as to business value. As such there is always the possibility of mistakes or error in business valuations.
These seven, “easy to miss errors” in business valuation can cause the business valuation opinion of value to be unsupportable or wrong. Whatever your business valuation purpose, ESOP, SBA, litigation, or estate work, make sure you know what to look for when reviewing a business valuation.
#1 – Did the Valuator use good professional judgement in the business valuation?
Business valuations have hundreds of judgment calls and assumptions. These assumptions and judgement calls are so layered that it is easy to miss many of them. This is because business valuation is forward looking. Namely, a central tenant of business valuation is that we are trying to understand the “foreseeable” future to estimate the value of the business. Because no one knows the future we look to the past and current situation to project the future.
What possibly could be more of a judgment call than predicting the future?
In addition, since a business valuation is not an actual “sale”, we have to make assumptions about who is the buyer and who is the seller along with the timeline for the sale. This is called a Standard of Value. (More on this later.) For instance a liquidation, or rush sale will have a lower value than a fair market value sale with a full marketing period.
Therefore, as you review or prepare a business valuation look at all of (or as many as you can track) the assumptions and consider if this is a fair representation of the likely future with what is known or knowable on the valuation date. In addition, since the math used to calculate the value is influenced (or should be) by the layers of assumptions make sure the calculations and final value found also make sense for the likely future of this business.
In business valuation, always apply the common sense statement,
“I would rather be approximately right rather than perfectly wrong”
#2 – In Business Valuation, Price is NOT Value
A price is what a buyer pays a seller. It is the culmination of a sales process. That process may have been a well-managed arm’s length market sale or it may have been a personal or non-arm’s length sale such as from father to daughter. Price can only be determined by buying and selling. Price involves a huge amount of emotion, luck, and in many cases deal terms such as the seller receiving part of the price over time through payments on a note.
Value is an “opinion” based on what is known and knowable to a defined standard of value and other assumptions as of a given valuation date. Usually it is assumed that the entire value is paid in cash at closing. The past is used to reasonably and rationally estimate the foreseeable future. Calculating an opinion of value does not include emotion or quality of the sale process.
Therefore price can and usually will be above or below the value. But, the two should relate. If you can’t relate them there is probably an error.
#3 – What is “known or knowable” as of the valuation date
Businesses are ever changing. Every day there are new opportunities and challenges. Therefore valuators establish a cut-off date when preparing a business valuation. That cut-off date is called the valuation date. The valuation date is not the same as the report date. The report date is the day the report is issued.
So, if my valuation date is December 31, 2019 and my report date is June 30, 2020, the only things I am supposed to consider in the six month period following the valuation date are things that were known or “knowable” as of the valuation date. Exactly what is knowable is a professional judgment call.
Sometimes the concept of a fixed date as time passes is relaxed or the valuation date is a moving target. This is common in divorce cases. Another example; if a valuation is prepared for an acquisition and a major change occurs after the valuation date the valuation may be valid as of the valuation date, but it is probably not useful to the parties.
This may all seem like silly semantics but think of the value of a sit down restaurant in Manhattan before and after the Covid-19 shut-downs. Therefore, pay attention to what is known or knowable as of the valuation date because change is constant.
#4 – Business Valuation – Standard of Value
In business valuation Standards of Value are shorthand definitions for who is my buyer, who is my seller, whose view (buyer, seller or both) are we looking at the value from and what is the time-frame for the sale.
This standardization allows business valuations to be comparable to each other and useful to reviewers and users. Standards of value are often specified by the purpose of the business valuation.
For instance, in litigation, the state or Federal rules that apply will often specify a standard of value. Valuations for tax purposes are specified to be fair market value.
Sometimes the standard of value is selected by the client. For instance for internal planning use, a client might select fair market value or synergistic value.
A few of the most common standards of value:
Fair Market Value – “The fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.” Rev Ruling 59-60
Note that this is not an actual buyer or seller including the owner or prospective buyer of a business but hypothetical buyer or seller. Further assumptions are that the price will be paid in cash at closing and the sale will happen relatively quickly (namely the interest is “marketable”).
Fair Value –For small business use, this standard is generally fair market value of a 100% interest divided pro-rata by the ownership interest. Namely marketability and minority interest discounts are not applied. If a minority owner owns 7% of a business with a control value of $100,000 the value is $7,000. Under fair market value after discounts it might be $4,000. This standard is often specified by statute to protect minority interest holders in businesses.
Synergistic Value – “A price or potential price reflecting all or some portion of the value of synergistic benefits created through the combination of the respective entities” Shannon Pratt.
A simple example of a synergistic value is two delivery companies with half empty vehicles going on the same delivery routes. If they merge the value of the target should be higher to this buyer than other buyers because the combined entity will have higher earnings (fewer drivers, and fewer full trucks) than the target generates on its own. If many market buyers may have the synergy available then synergistic value can fall under fair market value. Usually it falls under investment value below.
Investment Value – This is the actual estimated value of a company to another known company or buyer. Investment Value is the opposite of Fair Market Value in that both the buyer and seller are known and the value is estimated to them as opposed to hypothetical buyers and sellers.
Along with standard of value is premise of value. There are two main premises, going concern where the company is assumed to continue and liquidation where the company is assumed to be dissolved.
Clearly assumptions specified in the standard of value can greatly affect the value found. Make sure the valuation calls out the correct standard of value for the purpose of the valuation and then applies that standard of value throughout the many assumptions, calculations and report.
#5 – Business Valuation – Cash Flow Normalization
For many people, cash flow is the main thing they think of when they think of business valuation.
For small business valuation the most frequently used cash flows are revenues, EBITDA or Earnings before Interest, Taxes, Depreciation, and Amortization, and SDE or Sellers Discretionary Earnings. SDE is essentially EBITDA plus all the ways one owner makes money including salary and benefits. Revenues are easy to identify but often do not indicate the earnings power of the company. Therefore they can be a less reliable indicator of value.
For business valuation, cash flows are first “normalized”. When normalizing the valuator attempts to adjust the cash flow to be similar to the cash flows used to develop a multiplier or discount / capitalization rate discussed below. Basically to create an “apples to apples” comparison.
Normalization involves several types of adjustments, comparability, one time or non-operating, and discretionary.
Comparability adjustments are to adjust how the company keeps their accounting records to fit the cash flow definition being used.
One-time adjustments are unusual and non-recurring expenses or revenues such as a loss from a onetime lawsuit. The valuator would remove the loss from the cash flow as they are unlikely to be predictive of future cash flows.
Discretionary adjustments are adjustments an owner may make for his benefit like having a non-working spouse on payroll. This situation may not occur with the new owner and are discretionary to the current owner.
Cash flows for the last three to five years are typically reviewed and adjusted.
Then depending on the valuation method being used the historic adjusted cash flows are weighted.
For instance if I have three years of data being reviewed for a business valuation, I could weight each year’s cash flow evenly to come up with an average or I could select one year to come up with one number for my future cash flow. The other alternative used in some methods is to develop a projection of likely future results. With small businesses this can be difficult. How the cash flow is selected or determined can greatly swing value and needs to be carefully considered.
Either way, the valuator is trying to estimate a future cash flow. Therefore even if historic results are strong but an intervening event has occurred (think Covid with sit-down restaurants, or a convenience store that lost its lease), the future cash flow may vary from the past.
In the end, cash flow in most cases is one of two major factors used to calculate an indication of value. All of the assumptions and adjustments, and perhaps even the calendar years of data (3 years or 5 years or some other figure) used to determine trends of the company need to make sense and be reasonable.
#6 – Selection of the Multiplier or Discount/Capitalization Rate
In business valuation a great deal of time and effort is spent on the financial information or numbers. But, behind the numbers is a business that generates the numbers. This business may have great systems and people and be highly resilient or it could be a few overworked people doing everything from the seat of their pants. Evaluating the business itself and what we call, “soft” factors is very important. This information is then used to determine the risk factor of the business. The risk factor is then applied against the cash flow selected to determine value. For example in the market method market comparables are reviewed against the subject company (both financial information and quality of the company) and then the starting point indication of value is determined using the formula below.
Market Method: Cash Flow X Multiplier = Value
It is easy to hedge a risk factor a little high or a little low. If the valuator also hedged the cash flow in the same direction the indication of value can be seriously different from what would be the correct value found. Therefore always apply a sniff test or judgment test to the multiplier, capitalization rate, or discount rate used.
#7 – Business Valuation – Weighting of Methods to Determine Value
Calculating the indications of value is simply applying the cash flows to the multiplier or discount or capitalization rate. Often multiple business valuation methods will be used to estimate value. Then sometimes one method is selected or the different methods will be weighted to come up with a value.
For instance the value found under the market method is $200,000 and the value found under the income method is $250,000 the valuator might pick either method or weight them. If weighted 50% each then the value would be $225,000. It is important that there be a valid logic in this weighting that ties into issues with the valuation methodologies, the overall company situation and likely future based on what is known and knowable as of the valuation date.
Finally the value estimated based on cash flows should be adjusted as appropriate for extra assets included or excluded in the valuation method assumptions. A typical adjustment could be for inventory.
For instance, with restaurants inventory under the market method is often added to the indicated price and depending on the source of comparable data.
Working capital with small businesses is another source of adjustment. In small company transactions owners often keep the working capital (cash and accounts receivable). As companies get larger working capital is more likely to be included in the price. Again, this is another area where professional judgement must be applied particularly with companies between one million and five million dollars of value.
Each method should be reviewed and the weighting itself should be reviewed for reasonableness. Any adjustments for included or excluded assets should be made and also reviewed for reasonableness. Valuation it an iterative process.
Always finish developing or reviewing a business valuation by remembering Tip 1 – “I would rather be approximately right than perfectly wrong.”
Conclusion:
Business valuations are quite technical. If it is your business and your life being affected by the valuation, or if you prepare or review business valuations, you want make sure the valuation is right.
The book, “The Art of Business Valuation, Accurately Valuing a Small Business” covers many professional judgement scenarios, explains calculations and standards in great detail and addresses other important valuation issues. You will also have web access to download sample reports, calculators and checklists. You will reach for this complete resource time and again.
At 1:00 PM, October 20, 2021, Gregory Caruso is giving a two hour presentation to the Rhode Island Chapter of the National Association of Certified Valuators and Analysts (NACVA).
The business valuation presentation is based on the methodology explained in Greg’s book, “The Art of Business Valuation, Accurately Valuing a Small Business.” The primary focus will be on using the market method to evaluate small and micro businesses with revenues below $10 million.
Versions of this presentation can be given from 50 minutes to 3 hours. We also can provide CPE for most CPA groups. This and other presentations can be modified to fit many groups with an interest in business valuation, growing and exiting businesses.
Greg regularly gets high rankings (4.7 out of 5) from virtual audiences of up to 500 people.
Here are some recent valuations, which have sometimes been complicated by COVID-19. We recently analyzed a gym, a landscaping company, and physical therapy and chiropractor practices. We do small business valuations for SBA loans, exit and succession planning, and business mergers.
SBA Business Valuation of Fitness Center / Gym / Martial Arts Studio
The team at Harvest Business, LLC, and valuation analyst Gregory Caruso prepared an Opinion of Value for a bank and the SBA, for a fitness center, gym, and martial arts studio that was positioned in the high end of the discount gym industry. The gym was located on somewhat side roads near a major mall with signage and visibility from a major highway. The facility had been well maintained and the equipment was reasonably modern.
COVID-19 has been a problem for the gym and fitness industry. In this case, they experienced a dip in 2020 as the facility was closed for about two months. The number of members had dropped during 2020, but the very large membership was rebounding. A new martial arts director was onboard and increasing ancillary income from classes. Monthly data showed that the gym was recovering quickly therefore only a small reduction in value (compared to a possible 2019 value) occurred due to COVID.
A high value compared to the business valuation market data comparison set was warranted and found for this SBA Opinion of Value Business Valuation.
Landscaping Business Valuation for Exit Planning & Succession Planning
This was a specialty landscaping business that provides new installs of landscaping, mainly for home builders and developers. The company also provides sediment control and related services. The company has many inter-company charges with two related companies. Those inter-company charges were often made based on which company had the ability to pay the bills as opposed to true cost. Therefore, the inter-company charges had to be unwound in order to determine true future cash flow for business valuation purposes of the company.
In addition, the entrepreneurial owner had many other related investments that had to be sorted out and adjusted or removed as they are not part of a future continuing cash flow.
The company has had several very nice growth years increasing business value. However, it mainly serves a cyclical industry. Therefore, values tend to be moderated (as compared to pure reoccurring income type service industries) as is the case with most new construction oriented companies.
Chiropractor, Physical Therapy, Other Medical Therapy Business Valuations for Family and Management Buy Outs
We have had a bunch of these recently. Between the retirement of baby-boomers and upheavals in medical related fields, there has been a lot of interest in business valuations for transition in medical related industries.
While each of these was unique, we saw many of the same complicating factors. They had issues relating to billings vs. collections, and payers and payment reimbursement rates received is very important to these businesses. Another area of concern is the utilization of therapists and physical space used due to lower margins or mark-ups over therapists employment or contract rates that some other medical specialties.
Do you have a business valuation question or perhaps need a business valuation?
Business valuation market method multipliers are useful as rules of thumb or sanity checks on business valuations, calculations, and estimates. Below, I include many small business multipliers and industry multipliers such as construction, HVAC, plumbing, auto repair, manufacturing, accounting and service businesses, liquor stores, distributors, and more.
Many business owners just want the question answered – what is the business valuation multiplier for my business? Well, hang on. Using multipliers for business valuation is at best a rule of thumb and not a professional business valuation. Although sometimes, a multiplier is all you need.
Disclaimer: These business valuation multipliers are our best belief based on 20+ years valuing hundreds of small businesses and brokering over 60. The typical small business has an SDE multiplier range of 1 to 3, and 2.2 is about average. Again, using these multipliers is a rule of thumb NOT a business valuation. Always obtain a professionally prepared business valuation for major life decisions, tax matters, estate and gift tax planning, succession and exit planning, required fairness opinion or other compliance.
Watch the 1:35 Minute Video About Market Multipliers and
Rules of Thumb Below.
What is a Business Valuation Multiplier?
The market method valuation approach formula for valuing business is:
Future Cash Flow x Multiplier = Indication of Value
Multipliers are estimated by taking reported business transactions and dividing the sales price by the business’s reported cash flow. This is the only method that ties to actual sales in the marketplace. In an actual business valuation, there are several other additions to the formula. These include adjusting the cash flows, adjusting the balance sheet, and taking into account discounts and premiums. All of these can impact value. Business valuation is more than this simple version of the market method formula.
There are several cash flows commonly used including revenues, Sellers Discretionary Earnings (SDE), and Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) in the market method. There are other cash flows occasionally used or used in different industries including gross revenues, EBIT, after tax cash flow and more. I recently shared more about cash flows in “Five Cash Flows Used in Business Valuation.”
It is important to align the cash flow used with the proper multiplier. It is also important to adjust the multiplier based on profitability of the company, systems, employees and contractors, customers, products, inventory on hand, economic outlook, industry outlook, and many other factors. That is why just applying a multiplier to a cash flow without judgment can be so misleading.
How to Select the Right Multiplier
Most business owners select a multiplier that is too high. Certainly there are “high multiplier” companies out there, but often the cash flow multiplier actually drops as the company becomes more profitable. While this seems hard to believe, we have charted hundreds of companies and can assure you it is common.
When the market method is properly applied, multiple data points (usually 10 – 30) are obtained and compared to the subject company. Usually industry, revenue range, date range of transactions, and profitability range are all searched. It is important to chart the data by profitability. Comparables are then examined as a group. When appropriate, they are also examined individually to fully understand how the comparables really compare to the company being valued. We recommend DealStats from BVR as this is the best small business data at this time.
Multipliers Are Not Always Best in Business Valuation
As with all business valuation, professional judgment comes into play. While we are pleased to post these business valuation multiples for your use we highly recommend you have a proper business valuation performed by a professional business valuator–if it is to be used for anything beyond a fun conversation.
We are always available to serve you in that capacity. Contact Greg Caruso for more information about professional valuation services.
