A closer look at how the marketplace values private businesses and how the appropriate market multiple can be determined…
Various advisors are always throwing out market multiples to assist clients in determining the value of their business, but where do they come from? This article intends to review how the marketplace arrives at the value for private businesses and provide resources business owners can utilize in determining the appropriate valuation multiple for their business.
Buyers will often focus on the earnings of a business and apply a multiple to the applicable income stream. The most common income stream measures are as follows:
- EBITDA—earnings before interest, income taxes, depreciation and amortization;
- EBIT—earnings before interest and income taxes; and
- Owner’s cash flow (discretionary earnings)—earnings before interest, income taxes, depreciation, amortization and any compensation to the owner.
Obtaining the highest market multiple for selling a business is extremely important, but it is typically controlled by outside factors, such as the business’ industry. However, a business owner can maximize his or her selling price by analyzing the components of the business’ historical earnings.
Hypothetical adjustments to historical financial results are frequently necessary to provide insight into what prior operations might have looked like under normal conditions, how operations compare with other companies in a similar industry, and what a buyer might reasonably expect to obtain as a return from the business in the future, using history as a guide. These adjustments to historical earnings produce what is known as normalized earnings. Normalized earnings are defined as the economic benefit adjusted for nonrecurring, noneconomic or other unusual items to eliminate anomalies and/or facilitate comparisons. Potential adjustments when calculating normalized earnings are listed below:
- Excess fringe benefits, including healthcare and retirement
- Excess employee perquisites
- Excess (deficient) rental payments to the business owner
- Nonbusiness travel and entertainment of the business owner or key employees
- Related-party transactions (not completed at an arm’s length)
- Changes in accounting principles (switch from LIFO to FIFO inventory)
- Nonrecurring items (legal fees due to litigation)
- Insurance proceeds from a property or casualty claim
- Discontinuation of operations
- Other discretionary items (e.g. charitable contributions).
Making these adjustments could be compared to the steps taken by homeowners before selling their house. Minor projects are performed to get a home in its best shape before placing it on the real estate market. Similarly, business owners should review their historical earnings so they may be presented in the best light before being presented to a potential buyer. Another item to consider is the outlook for the business. If there is significant growth on the horizon, projected income statements outlining such growth should be presented to a potential buyer. While normalization adjustments can be a positive to a selling business owner, a buyer may correlate numerous normalization adjustments with that of a poorly-run business, since the original financial records do not provide an accurate portrayal of the business.
The following illustrates how a business with pre-tax earnings of $100,000 could generate a lower selling price than a business with a normalized pre-tax return of $125,000, despite having a higher market multiple applied to its income stream:
Where Do Market Multiples Come From?
Market multiples are determined based on an analysis of prices paid by investors in the private or—most often due to the availability of information—public markets for the stock of other companies in the same or similar lines of business. This methodology requires adequate information concerning prices paid in transactions for the stock or assets of an acquired business.
There are three main categories from which market multiples are derived:
- Publicly-held companies
- Privately-held businesses
- Rules of thumb.
The notion behind the market multiples for publicly-held companies is that prices of publicly-traded stocks in the same or a similar industry provide objective evidence as to values at which investors are willing to buy and sell businesses in that specific industry. Some market multiples for publicly-held companies—for instance, price to earnings (P/E)—can be readily accessible through various financial websites, while others can be computed utilizing financial statements available for publicly-traded companies in the form of 10-Ks and 10-Qs. The market capitalization (share price multiplied by outstanding shares) of the public company is divided by the income stream to obtain the market multiple.
While there may be few, if any, publicly-held companies that are comparable to the small local business, there are databases available that have accumulated market multiples for transactions related to the sale of privately-held businesses. Typically, no reliance is placed on an individual private transaction; instead, the average or median market multiple for a given industry carries more weight as the individual transactions constitute part of an overall market. The three most prevalent transactional databases for privately-held businesses are:
- Pratt’s Stats. This database contains data variously described as merger and acquisition transactions, private company deals, and private merger and acquisitions transactions. It provides up to 100+ data points per transaction highlighting the financial and transactional details of the sales of privately and closely-held companies. The database collects private business transactions of Main Street businesses from business brokers, as well as middle-market merger and acquisition deals where a public company purchases a private company.
- BizComps. This database includes over 11,000 transactions, with approximately 1,200 to 1,400 new transactions added each year. BizComps provides more than 70 data points of various types of businesses.
- Institute of Business Appraisers Market Database. The IBA Market Database is comprised of more than 37,000 transactions of privately held businesses, with over 9,600 transactions occurring in the past five years.
It is implied that rules of thumb are derived from actual sales of businesses; however, no details are available regarding the transactions on which the rules of thumb are based upon. For more than 20 years, the Business Reference Guide has been the essential guide to rules of thumb, providing business transaction professionals with up-to-date market multiples for 700+ types of businesses. It is the most simplistic, and likely most cost-effective method of obtaining market multiples for a given industry. Due to the simplistic nature of rules of thumb, one should not over-rely on market multiples from these sources. Additional due diligence of a market multiple would need to be done if an actual acquisition or sale of a privately-held business were to take place.
Application of Market Multiples
When applying a market multiple to an income stream, it is important to know what the data from the above resources represents. There are differences in how the data is reported among the databases that report transactions of privately-held businesses and what assets may be included in their selling prices. The application of a market multiple from the Pratt’s Stats database to a normalized income stream generates an asset price. An asset price under this formula would include the fair market value of any machinery, equipment, vehicles, goodwill, blue sky or other intangibles owned by the business. However, this price is typically believed to not include the selling business’ cash, accounts receivables or inventory, nor would it include the assumption of any liabilities. Please refer to the following illustration of this basic calculation:
If a business owner is seeking a value for the stock of his or her business, an asset price can be converted to a stock price by simply adding/subtracting net working capital, subtracting interest bearing debt, and adjusting for any non-operating assets or liabilities of the business (e.g. real estate owned by the business). The following table illustrates the conversion of an asset price to a stock price:
For a privately-held business owner, industry-based market multiples are available through a variety of resources. A business owner should have a general idea as to the value of his or her business in order to be prepared for a potential acquisition offer, corporate succession planning and personal estate planning. In the event of an actual acquisition, merger or sale, it is recommended to seek the guidance of a knowledgeable professional in order to determine if the market multiple being proposed for a transaction is being applied appropriately. iBi
Nathan Isenberg, CPA, ABV is a manager at Heinold Banwart, Ltd. He can be reached at (309) 694-4251 or [email protected].