Business valuations – part 2

June 20, 2017

In the last post, I talked about the selection of “profit” in the relatively simply formula for valuing a privately owned business:

Business value = Profit x Multiple

So what is the multiple and where does it come from?

The multiple represents a benchmark or comparison to another business that is similar. The multiple is really just a factor that is applied to profit, being 2 or 3 or more.

The idea of a multiple is the same for when you are trying to value your house – let’s find recent evidence of property sales in your street, suburb or general area. We then make adjustments for the quality, land size, location, number of bathrooms, pool, off street parking and general appearance of your house compared to the evidence. We also adjust for market sentiment and feel good factors.

For a business, the multiple can be calculated based on recent evidence of business sales – in the same industry, similar location, similar size, etc. Adjustments are made for relative size, location, profitability, market position, competition, key person risk, and so on.

The trick is finding a comparable business that has recently been acquired which can be used as a benchmark, as well as digging up the sale price, profitability and other information the buyer/vendor is unlikely to share.

This is the science part of business valuations.

The art, or black magic as one prominent judge described it, is in the adjustments.

I like to think of a multiple as two things:

  1. Growth – has your business grown historically or is there opportunity for growth?
  2. Risk – being customer concentration, key person risk, profit lumpiness, etc.

Put simply, the higher the growth profile, the higher the multiple will be. The higher the risk profile, the lower the multiple will be.

Many private business owners consider that value can be created by increasing profits. True, value tends to increase with profits, but there is a compound effect if the risk profile is reduced over time.

I will talk more about the “risk” factors in selecting a multiple next time…

Lachie

CA BV Specialist