Selling a Business: Using Multiples to Find Value
Business owners that are semi-literate about selling a business often come to us with some pretty wild ideas about what their business is worth. Some expect the value of their business to be a “multiple” of something; monthly sales, net income, annual revenue, inventory and sundry other benchmarks that may or may not be important to a business’ value. But while the multiple is important when selling a business, it is FAR less important than what the multiple is multiplying!
Business owners – especially the owners of Main St and lower Middle Market businesses – often have an inflated opinion of the value of their business. This is an issue we’ll tackle in a future post but for this post we want to focus on the definition of the multiple and, more importantly, what it should be multiplying!
What is a “Multiple”?
Owners come to us saying that they believe businesses sell for “five times this” or “eight times that” or “one times something else”. That is, they feel that their business – or any business – will sell for a “multiple” of something whereby they multiple some number – monthly sales, net income, annual revenue, inventory, etc – by some other number – one, five, eight; the “multiple” – and they will find the value of their business. Some even tell us that they invest in public companies and know that the average multiple of the S&P 500 index is “X” (24.93 as I write this) and, as such their business should use a multiple close to that when determining value. This suggests that a dollar of earnings for Pete’s HVAC business in Podunk, Idaho is worth as much as a dollar of earnings of Exxon. This, of course, is ludicrous!
Publicly traded companies trade at higher multiples than private companies for a number of reasons, chief among them is that publicly traded companies involve FAR less investment risk than private ones. Ask yourself this question: would you rather invest $100,000 in Pete’s HVAC business or in Exxon? In which of those investments would you feel that your money was safest? This is such an easy decision, there is no need to use publicly traded companies in any equation that purports to value private companies.
The same is true for large private companies. For example, investing in Intrepid Healthcare Services, a home healthcare business with dozens of offices in the United States, will be less risky that investing in Harriet’s Happy Home Health Honeys LLC, a 12-employee “Mom and Pop” that provides the same services. And “investing” is what buyers do when they buy a business.
So, “the multiple” is the answer to the following calculation: sales price (value) divided by The Most Important Number (“TMIN”). But, of course, even though finding a multiple number for your type of business is relatively easy, you can’t do the calculation because you don’t know what the value of your business is. You first have to determine what The Most Important Number is. Then you can calculate the valuation.
What Is The Most Important Number?
Before we determine what the multiple is, we have to determine what the multiple is of.
Every business that transfers from one ownership group to another, sells for a multiple of a dozen or more data points. The sale price will be some multiple of monthly sales, net income, annual revenue, inventory, officers’ salaries, the number of full moons in the past three years and the number of times the owners’ mother-in-law decried the child-rearing methods of her daughter. But of all the numbers that you can apply a multiple to, there is only one that means anything: true net, better know as “discretionary earnings“. This is The Most Important Number.
A buyers’ main concern is “how much of this company’s revenue can we put in our pockets?” If the business is doing even moderately well, everything else is of secondary importance. Sure, revenue figures are important and a buyer would like to see a trend of increasing revenue. And, yes, inventory is a crucial component of a business’ value, but the most important number is discretionary earnings exemplified in the following question; “If we buy this business, what can we make?” And the questions a buyer will subsequently ask are, “What am I willing to pay for those earnings? What kind of return do I want from my investment? How quickly do I want this business to pay for itself?”
So, What Are “Earnings”?
Let’s start with a statement of what earnings are not. They are almost never the taxable income on the company’s tax return or the bottom line on the company’s profit and loss or operating statements. Financing decisions, depreciation schedules, management’s decision to expense certain “owner benefits” all reduce taxable or net income but almost never reduce discretionary earnings. Though there are links in this post to other posts that give some details of and methods for determining what discretionary earnings are, let me give you an example of an expense that is actually an owner benefit – and should be calculated as a component of discretionary earnings.
No matter what business you’re in, your industry has an association and that association has large and small, national or regional meetings. It doesn’t matter whether you’re in Frankfurt, Germany or Frankfurt, Kentucky, your association might have its regional meeting in Heidelberg and Louisville and its national convention in Tenerife and Honolulu. You could spend EUR 1 500 to attend the meeting in Heidelberg and $2,000 to attend the meeting in Louisville – OR you could spend EUR 15 000 to attend the meeting in Tenerife and $20,000 to attend the one in Honolulu. The difference is “discretionary earnings”; EUR 14 500 and $18,000 respectively. The choice to attend the more interesting and exotic locale was made at the discretion of the owners of the business and they benefited personally with a couple of days of sailing and paragliding, enjoying sundry frozen and umbrella infused adult beverages by the pool and returning to whichever Frankfurt they originated in with dim memories of debauchery and a fabulous tan!
Discretionary earnings is the amount of money that a business puts in the pockets of the owners no matter how they spend it. Once you know what they are, you – or if you’ve exhibited a level of acumen that suggests you are one schmat cookie, the professional business broker that you hired – will be able, with some research, to determine what similar businesses have sold for as a multiple of their discretionary earnings. You multiply your discretionary earnings by the “multiple” at which businesses in your industry have changed hands and you will arrive at a number that will closely align with what the market will value your business at.
Let’s Try an Example
Our database contains sales information on 313 “limited service restaurants” that sold in the past five years. “Limited service” includes fast food, pizza, bakeries, delis and other similar restaurants. They sold for a range of .24 to 27.83 times discretionary earnings. Now, this is a huge range and such data is hardly helpful. After all, if you’re the seller, you want your business to be valued at 27.83 times its earnings – a number that would make it 26% more valuable than Exxon on a price-to-earnings basis.
Those numbers are virtually useless. But we also see that the average of the 313 multiples was 2.13 times earnings. Now, this is a little bit more helpful but we want to fine-tune it even more and we do so by reviewing all 313 records and removing outliers, instances where the data is so far out of the norm that they skew the overall results. Because the vast majority of these businesses sold for less than four times earnings and that few viable businesses will sell for less than one times earnings, we went through the list and removed every one that sold for four or more times earnings as well as every one that sold for less than one times earnings. We ended up with 230. The range was 1 to 3.96 and, on average, they sold for 1.87 times their earnings.
By multiplying the earnings of a limited service restaurant by 1.87, you will arrive at a number that will be pretty close to what the market suggests is the value of that restaurant.
If you’re thinking of selling a business, the first thing you must do is find out what the market suggests is the most probable value. The first step in that process is determining the discretionary earnings – the business’ true net. Aside from its importance as a measure of value, it is what a buyer will be most interested in and what that buyer will based its two major decisions on – whether to consider your business a viable candidate for acquisition or not and, if so, at what price. If you don’t pay attention to this and you put an unrealistic price on your business, you will likely be the owner of that business for many years to come.
If you have any questions or comments, put them in the Comments box, below. I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast.
I’ll be back with you again next Monday. In the meantime, I hope you have a profitable week!