The business valuation formulas used to compute the value of a business for sale are numerous and can be confusing to many small business owners. In fact, many professionals can be similarly confused by the various multiple formulas currently in use.
When pricing a business for sale, a valuation multiple is applied to either revenue and/or earnings and then often adjusted to account for assets and liabilities which may be transferred to the buyer when the business is sold. Additionally, every business buyer will apply adjustments to the value of a prospective acquisition based on a specific perception of risk as the new business owner as well as future opportunities.
The actual ‘multiple’ varies widely by industry. It also increases and decreases according to how well the economy at large is performing in addition to the performance of financial markets and the cost of capital available for investment purposes. Accordingly, a given business, which produces a certain level of revenue and earnings, will be more or less valuable over time as its industry falls in or out of favor while the economy and financial markets ebb and flow. Suffice it to say a business owner can only control one of the four major factors which influence the value of his business — its revenue and earnings. Beyond that, he is at the mercy of his industry, the economy at large, and the condition of financial markets when valuing his business for sale.
Below we’ve defined the various measurements of revenue and/or earnings to which valuation multiples are applied from the various business valuation formulas for your reference. Along with each measurement definition you will find an explanation regarding when the valuation multiple formula is typically used.
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Seller’s Discretionary Income or SDE
A Seller’s Discretionary Income or Earnings consists of pretax profits before non-cash expenses (which is EBITDA, defined further below), owner’s benefits, non-recurring expenses, and any non-related income or expenses. SDE is used to value small businesses that typically have earnings of less than $1 million. Many small businesses are run by the owner, which is why the owner’s compensation is added back into the calculation of the SDE.
Non-recurring expenses refer to one-time fees such as licensing, facility renovation, new equipment, etc. The buyer will not expect to pay those costs every year while they are running the business, so they are also added back to the SDE. Many small business owners run expenses through their business even if they are not directly related to it, such as expensing the cost of an owner’s vehicle maintenance. With detailed record keeping, some of these owner expenses can be added back.
The multiples calculated with SDE depend on the size of the SDE; smaller SDEs result in smaller multiples from 1 to 2, while larger SDEs can pull multiples from 2 to 4.
Earnings Before Interest and Taxes or EBIT
Earnings Before Interest and Taxes represents a measure of a business’s earnings from operations. To determine EBIT, interest expenses and taxes that are not payroll related are added back to the net operating income. Payroll taxes, such as Medicare and Unemployment, are necessary to operate the business. Federal, state, and local taxes, on the other hand, are added back to the net operating income.
EBIT is a useful metric when comparing multiple companies within the same industry, because it disregards variations due to different capital structures and tax rates.
Earnings Before Interest, Taxes, Depreciation and Amortization or EBITDA
While EBIT measures operating earnings, EBITDA measures cash flow. EBITDA begins with the business’s net profit and adds back interest, taxes, depreciation, and amortization. This measure removes variations between companies with different financing and accounting practices.
A multiple is often applied to EBITDA to determine the value of a business. For smaller and middle market businesses, Brokers use an Adjusted EBITDA. This Adjusted, or Normalized, EBITDA takes into account non-standard income and expenses present in private businesses.
Using Gross Sales as the Basis for Business Valuation Formulas
Gross Sales refers to the total of all sales without any deductions for discounts, returns, or operating expenses. Gross Sales are commonly used in some industries to compute the business value, such as consumer retail and restaurants.
Even if multiples of gross sales are common in your business’s industry, many business valuations and buyers will still want to examine other measures such as net profit and gross profit margin.