As I’ve written about previously, the three main valuation methods each have their pros and cons. Understanding valuation means understanding when to use the Income approach, the Market Methods approach, and the Asset approach. Here are some basics about these approaches, and when to use them.
A Profitable vs. Unprofitable Business Valuation
As much as business owners hate to admit it, there are unprofitable businesses. However, this doesn’t mean that you can evaluate a business, it just means taking a different approach. The Income and Market approaches are primarily used when valuing a profitable business. The Asset approach has methods that tend to be used for unprofitable or poorly performing businesses with significant assets.
The Income approach uses the Capitalization of Earnings Method and the Discounted Cash Flow Method.
The Market approach uses methods such as the Revenues Method, the SDE (Sellers Discretionary Earnings) Method, and the EBITDA (Earnings Before Interest, Taxes, Depreciation, Amortization) or EBIT (Earnings Before Interest and Taxes) Method. Each method is a different cash flow, and can be used for a comparison between the company that is being valued and a comparable company.
Small Businesses Can Benefit from the Income Approach
The Income approach is the most commonly used method for small business valuation, generally using the Capitalization of Earnings method. This is usually the best approach because of its simplicity and the fact that it can be applied to most businesses.
The Capitalization of Earnings method typically looks to the past 3 to 5 years of after-tax cash flow. This is used to estimate a cash flow for the future. This single cash flow figure is divided by a capitalization rate, commonly referred to as the Cap Rate. The capitalization rate is usually estimated using a Build Up method for the different risk levels from public market data made available by many sources including Business Valuation Resources (BVR) (https://www.bvresources.com/) and Duff & Phelps (https://dpcostofcapital.com/).
The Problem with the Income Methods for Small Businesses
The methods are not always perfect for small businesses. There is no quantifiable information linking small companies to public data–they don’t have to make their information public. This is less of a problem for larger small companies (those with EBITDA above $400,000), since there are several methods that appear to provide a reasonable starting point for analysis. These include the Duff & Phelps Navigator, using the Build Up in the Risk Premium Report Study section with the Regression Equation Method button turned on.
However, a smaller company may have insufficient cash flows for any other method than SDE to work. In this case, there is absolutely no data to estimate the Company Specific Premium. The Company Specific Premium is the adjustment used to bridge the gap between the public data and small company reality. There are no third party sources of Specific Company Premium for SDE cash flows. This means for smaller companies, the Cash Flow Market Method makes more sense. Fortunately, for these smaller companies there is usually more comparable market data making this method when properly applied quite supportable.
The Cash Flow Market Method for Small Businesses
Cash Flow Market Methods review the past to estimate a future cash flow. You select a comparison set of actual reported transactions from a transaction database. Then, this set is reviewed against the company being valued and a multiplier is selected. The multiplier is then multiplied against the cash flow to find the business value. I explain a very effective methodology for selecting and reviewing comparables in my book, The Art of Business Valuation, Accurately Valuing a Small Business, which you can purchase at this link.
There are legitimate issues and concerns around quality of the comparable data when using the Market Methods. Yet, with enough data points (which doesn’t have to be that many, depending on the data set) and analysis, you can reach a high-level supported comfort. For businesses with SDE under $500,000 and EBITDA under $400,000 the Market Method Cash Flow is usually the best way to value a business.