Methods of Valuing a Business
EBITDA Multiple vs. Net Asset Value
One of the very first discussions we have with a newly engaged client is how their business will likely be viewed by prospective buyers in terms of financial value. While it’s obviously an important topic that that requires a fairly in-depth analysis, business owners should nevertheless understand the basic components of how a valuation is formulated.
For most non real estate operating businesses, a valuation range can be determined through a “market approach” (i.e. what are similar business selling for in the marketplace) and/or an “income approach” (i.e. how much cash is generated from the business over time).
To arrive at a market-based valuation, a researcher typically studies comparable transactions for private and public companies and public market trading data for public companies.
In most instances, however, buyers are most interested in the company’s ability to generate cash through utilization of all the underlying assets.
The most often used method of determining how much cash is generated by a company is referred to as an “adjusted EBITDA” calculation, which looks at current and historical earnings before interest, taxes, depreciation, and amortization.
For buyers, an adjusted EBITDA analysis tells them how much cash will be delivered by the company once they own it. As part of the calculation, higher than average owner salaries and other discretionary expenses are adjusted to show a normalized post-close income statement.
Using the adjusted EBITDA amount, prospective buyers will then apply a multiple to arrive at the company’s value range. The exact multiple can reflect numerous variables including company and/or industry growth, competitive advantages, intellectual property, profit margins, the size of the business, and the general level of risk associated with producing the cash flows. Ideally, a buyer would have sufficient cash from the acquired business to cover the cost of acquisition within three to five years.
So what if the company doesn’t have much in the way of earnings, but is sitting on a lot of valuable inventory? In this scenario, a seller might want to consider selling their business based on its “net asset value.” This approach looks at the verifiable value of each asset including equipment, inventory, accounts receivable, etc. along with all the liabilities that would have to be satisfied upon a sale of the business.
Generally speaking, using an EBITDA multiple will yield better value for the seller vs. the net asset approach. Also note, a buyer couldn’t reasonably be asked to pay an EBITDA multiple (remember, the cash generated by all the underlying assets) on top of a separate payment for the company’s assets. In effect, that would be asking a buyer to pay twice for the company.
As in all matters related to the sale of a major asset, sellers would be doing themselves a big favor by consulting with a knowledgeable valuation specialist. Please contact Protegrity Advisors to discuss your specific situation.