Should You Use Valuation Multiples for a Small Business for Sale?
There are ‘rules of thumb’ when using valuation multiples in a business for sale. It is especially important that small business owners take note of, as valuation multiples should not be used simply in all scenarios. They are a quick way to value a company but are more commonly used for publicly listed companies or for established businesses in well defined industries.
1. The Multiple Of Turnover Does Not Always Equate To A Business’ Value
The belief: take the turnover and multiply it with a particular number, and that is the ‘real’ or approximate business value.
In reality, this will have several issues because sale numbers can be easily manipulated. For example a business can do so by selling an item then buying it back at the same price, and then repeat the process until the desired turnover is achieved.
There are exceptions where turnover can indicate a general view of a business’ value. Within the tech sector for example, where turnover can be used as a proxy for the market share. In such cases, market share has first to be defined and a general estimate of the total value. Take for instance a business with $100 million turnover in its market that is worth about $150 million in total would have the major share of the market and hence has the competitive advantage.
A business with the major market share would usually be evaluated based on its turnover or the percentage of its market influence and other factors.
2. The Multiple Of Profit Does Not Always Equate To A Business’s Value
The belief: take last year’s profit of the business and multiply it by a ‘magic number’ and that is the business valuation.
Similar to the previous point, there is no logic in this belief because profit is not the only determining factor of business value – two businesses generating exactly the same profit may have (i) contrasting asset profiles or (ii) different prospects.
(i) There is a chance that one business would own a property worth several millions while the other has no fixed assets. The former then has more value in addition to its earnings hence it has a higher price in the market.
(ii) One business may be highly dependent on the owner while the other may have a sound management team with a healthy historical financial growth. Hence the latter will naturally be more attractive to buyers and achieve more times the profit after the sale transaction; the former may struggle to get even one times the profit.
3. Using Multiple of Earnings & Other Numbers
Business values calculated using the ‘multiple of earnings’ are usually done after the sale transaction by a neutral third party; the multiples are then expressed in graphs that help to analyse median multiples.
The ‘multiple of earnings’ is related to the industry. Some industries have higher multiple, which can be an illusion for two reasons:
- Median values are not the full range of possible multiples for the industry.
- Some industries, such as manufacturing, have higher infrastructure costs so their businesses have higher profit margins and a higher value of net assets.
Also, the EBIT (or EBITDA or Seller’s Discretionary Earnings) can be manipulated, hence reiterating that by plainly using multiples will not be an accurate way to value a company.
In conclusion, ‘profit’ is only a part of the calculations, not the only criteria for business valuation.
What about ‘gross profits’?
This is about net profits after all the expenses. Buyers pay little attention to GP as they are more interested in what they will be receiving after the transfer of ownership, and how they can keep it.
For a business, having varied business valuation results from different valuation methods allow adjustments for the subjective factors involved in a business valuation. Hence even the law does not advocate a particular valuation method and they decide on a case by case basis.
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