How Small Business Valuations Differ from Large Business Valuations

How Small Business Valuations Differ from Large Business Valuations

by | Jun 30, 2021 | Technical Business Valuation Topics

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. Remember, you can evaluate a unprofitable 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.  

We always stress that valuation is not a strict science, but an art. To find out more about professional valuation services for your business, contact me to learn more.

Small Business Valuation, Asset, Market, Income Approaches

Small Business Valuation, Asset, Market, Income Approaches

by | Feb 13, 2021 | SBA Business Valuation and Appraisal

There are three business valuation approaches or methods:

The Asset Approaches are where the individual assets of the business are valued as if they were being sold.

The Market Approaches are where comparable market sales are used to estimate a value of the company.

The Income Approaches are where the risk to investors is compared to all investor investment choices to determine value.

More detail below:

The Asset Approaches are where the individual assets of the business are valued as if they were being sold.  This is usually used for non-performing businesses that may be liquidated.

The Market Approaches are where comparable market sales are used to estimate a value of the company.  The formula is the cash flow times the multiplier equals the value (or $100,000 cash flow x 2.2 multiplier = $220,000 value).  The multiplier is developed by looking at the sales price of the comparable sales data usually obtained from reporting services and dividing it by the cash flow.  (Multiplier = Price / Cash Flow or $100,000 price / $50,000 cash flow = a multiplier of 2.)  For very small businesses these comparable businesses may be mainly owner operated businesses.

When reviewing the various market methods a major concern is the comparability of the selected comparable companies to the company being valued.  Are they similar or very different?  In addition the valuator needs to make reasonable adjustments for overall risk of the company being valued vs. the comparable set.  For instance a company with two clients each at 50% is much more financially risky all things being equal than a company with 100 1% revenue clients.  The multiplier should be adjusted to reflect company risk vs. the likely risk in the comparable set.

The Income Approaches are where the risk to investors is compared to all investor investment choices to determine value. Public market data is used to develop a discount rate.   The discount rate is divided (along with present value adjustments) into a projected cash flow in the discounted cash flow income method.  This is a quite complex formula.  A more commonly used income method with small businesses is the capitalization of earnings method.  In this method a capitalization rate which is a discount rate minus a growth rate is applied to historic earnings adjusted by the growth rate for the next year (selected historic cash flow of $100,000 and a 3% growth rate = $103,000 adjusted cash flow / .25 (a discount rate of .28 – .03 growth) = $412,000 value).  Discount rates are generally developed for very small businesses using the build-up method (also called the BUM).  In short, the cost of capital for different layers of business risk has been calculated looking primarily to public companies and public information.

Each layer of a build-up should be carefully reviewed to make sure it was developed correctly as of the proper valuation date.  The last layer in the buildup method is specific company risk which is valuator judgement where all of the specific strengths and weaknesses of the business are accounted for that may impact Risk.    Note that Risk for business valuators is the perceived likelihood that future cash flows will not be met.

In all cases there is tremendous judgment in estimating a multiplier, discount or capitalization rate.  Which method to use depends on the facts in the case and the available data.  For smaller and micro businesses (I define as usually under $10 M revenues) there often is quite a large amount of market data which should favor using that method.  For businesses over $10 M in revenues there may not be enough relevant data to use the market method.  Then the income method is likely to be the best method.  Remember, methods are models and none are perfect.  We must select the best method based on all factors.  That, is professional judgment at work.

In all cases, use common sense. Make sure the selected value ties into the risk (and has some relationship to a price someone would pay) of the company including likely economic, industry, and other foreseeable changes in the future.

Greg Caruso, JD, CPA, CVA, the author of “The Art of Business Valuation, Accurately Valuing a Small Business” 2020 published by Wiley is always available to prepare (or review) business valuations for all purposes and situations.