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Comparables/ Rule of Thumb Business Valuation
The rule of thumb business valuation approach values the subject business based off of the selling price data from recently sold similar businesses. The concept of valuing a business in this manner is similar to how homes are valued in the real estate market. Typically, homes are valued relative to recently sold homes in the area, with the recently sold homes’ data adjusted to be more comparable to the subject home to be sold. By applying this same principle to the business valuation market, the goal is to calculate a business valuation that reflects the fair market value, or the “going rate,” in the market within which the business is operating.
A key consideration here is to utilize aggregated comparables data, adjusted for an apples-to-apples comparison. If data from only a few specific recent transactions in the market are used as a comparison, then it is quite likely that other, unknown factors that are impossible to verify, specific to those deals, might have heavily impacted the sales price. That is the reason why a large, accurate database is necessary for the market method of business valuation.
The subject business’s financial data is also very relevant for this business valuation method. It is key to find an accurate cash flow metric, usually the seller’s discretionary earnings (SDE) for small businesses with less than $2,000,000 in sales, to multiply by the comparables multiplier. After all, it will be counterproductive for a business buyer to calculate an inaccurate valuation by making an error on the primary input variable (near-term expected cash flow).
How is it calculated: Choose the appropriate expected future cash flow then multiply that figure by the appropriate multiplier
When to use it: if the subject business is generic and the market has a large amount of accurate comparables data available to use. Additionally, it helps to answer the question of Does this make sense? if there is a different valuation or price to compare it to.
Pros
- Utilizes actual data based on actual historical transaction prices
- Relatively simple to calculate
- Assuming good data, it can give the business buyer an overall accurate figure for how similar businesses are being valued
- Experienced valuators typically understand the issues with comparables data and can therefore adjust to accommodate for them
Cons
- Very reliant on accurate, quality comparables data in order to figure out the most accurate and appropriate multiplier to use
- Every small business is different, with many affected by local competition. The multiplier can be too broad to use given the specific characteristics of a given business for sale
- There is no data on the 75% of small businesses that did not sell, thereby skewing the comparables data, which is based only on sold businesses
- Need to ensure that you are comparing “apples to apples” by using the same definitions of cash flow (either seller’s discretionary earnings, EBITDA, net income, etc.) as the comparables that are being used
Illustrative Example Business Case for Calculating Business Valuation Using the Rule of Thumb Approach
Example Business – Sarah’s Auto Repair Service Center
Now we can look at a simple example of how the market/comparables approach to business valuation can be used. Sarah is the business owner of an auto repair service center. The business has been open and operating for the past 10 years. It is performing well, with modest profitability and growth prospects. However, Sarah has decided that she would like to sell the business and retire.
A potential business buyer named Carlos has found the listing for Sarah’s business and would like to calculate a fair valuation for the business. As auto repair service centers are quite a common business, and Carlos/his business broker have access to recent small business sales transactions for the specific industry, they decide to calculate the valuation using the market/comparables method.
In order to calculate the valuation using this methodology, they will follow the below steps:
Step 1
Review of the historical financial data from the recent years as well as the projections for the business
Step 2
Select which expected cash flow metric to use and calculate that expected future cash flow
Step 3
Select which multiplier to utilize for the valuation calculation
Step 3
Multiply the expected cash flow by the market multiplier
Calculating the Valuation
Step 1 (data collection)
Carlos, the business buyer, requests the relevant financial data, including recent tax returns, profit and loss statements, balance sheet, cash flow statement, and projections of the business, in order to gain a better understanding of the business. Accurate data is incredibly important when calculating the expected cash flow of the business as the expected cash flow will be used to calculate the valuation of the business.
Step 2 (cash flow calculation)
Carlos, with the help of his accountant, calculates the seller’s discretionary income (SDE) of the business as it has been shown to be the most reliable cash flow metric to use for small businesses, especially businesses that have less than $2,000,000 in top line sales. In order to do this calculation, adjustments to the near-term projected profit and loss statement must be made. These adjustments include removing non-operating or non-recurring expenses from the business. Examples of these expenses include Sarah’s personal vehicle costs, which are on the company’s profit and loss statement as expenses. Once the SDE is calculated, Carlos can move onto step three.
Projected Income Statement
| Pro Forma | SDE Adjusted | |
|---|---|---|
| Revenue | $1,000,000 | $1,000,000 |
| Cost of Goods Sold | $300,000 | $300,000 |
| Gross Profit | $700,000 | $700,000 |
| Labor | $250,000 | $250,000 |
| Rent | $100,000 | $100,000 |
| (Selling, General & Administrative) | $150,000 | $75,000 |
| Net Operating Income | $200,000 | $275,000 |
Note that in this example, an adjustment was made to decrease the SG&A (selling, general & administrative) expenses of the business as it was found that the business seller was running a number of non-business related expenses through the business, including his personal vehicle, vacation travel expenses, and the family cellphone bill.
Step 3 (selection of market multiplier)
Carlos must now figure out which market multiplier to use for the valuation calculation. He, with the help of his business broker, is able to obtain the aggregated data showing for what multiplier of SDE comparable businesses have sold for recently. There are a multitude of online resources that have this data available for individuals and business brokers who are in need of accessing it. Carlos’s business broker adjusts the comparables data in order to make them as comparable as possible to the SDE calculated in step 2. Of primary consideration are the below factors:
- Trend of cash flows including revenues and measures of profitability
- Management structure and size of company
- Concentrations or unusual risks or reduction of risk
- Clarity of comparables
- Any known local market comparables (reported or not)
- Comparability of subject company to comparables
- Profitability charting and comparison to subject
- Timing of economic cycle
- Industry trends
- Any material factor not included above
Multiplier
2.0
Step 4 (calculation of valuation)
With the calculated expected future cash flow and comparables multiplier in hand, Carlos can now calculate the value of Sarah’s Auto Repair Shop using the market/comparables method. Below is the calculation:
Calculation of valuation
| Expected Future Cash Flow | Multiplier |
|---|---|
| $275,000 | 2.0 |
| Estimate of Value | $550,000 |
Summary
With the steps completed, Carlos can now negotiate the price of the business confident that he has a valuation that makes sense for the type of business he is looking to acquire. The end price of the business will very likely be different from the valuation that has been calculated due to a variety of factors. However, it is important to have a calculated valuation in mind during the negotiation in order to avoid overpaying for a business that will not provide the requisite investment return to make the investment worthwhile.
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