Business valuations are completed for a long list of reasons. The results of the valuation will vary significantly based on the purpose of the valuation. The purpose will determine the level of detail, complexity of analysis, degree of due diligence, and the amount of legal reps and warranties required. In the marketplace, most often you will hear a business value described as 2.5X normalized income before tax, or 5X net profit after tax, or 1X gross revenues, etc. While you develop a sense for what a business might be worth, you must also develop an understanding of what type of valuation process makes the most sense.
For simplicity, we will demonstrate a simple valuation based solely on normalized Earnings Before Interest Taxes Depreciation & Amortization (EBITDA).
According to the Corporate Financial Institute, EBITDA is
“a metric used to evaluate a company’s operating performance. It can be seen as a proxy for cash flow from the entire company’s operations.”
This is not meant to address the multiple variations and calculations a Certified Business Evaluator (CBV) would process and calculate. This model simply demonstrates the impact of the most common rule of thumb/snapshot estimate of value: EBITDA times some multiple.
The EBITDA method is the simplest to calculate, however it carries the greatest risk of misrepresenting the real value of the business when only one year is observed. For example: if the last year was the best year ever, you are most likely over valuing the business. If the last year was the worst year ever, you are most likely undervaluing the business.
You will develop a better sense of value by applying some form of weighted average for a period of time. In the chart below, we make use of 5 years, however you can use as many years as you like. We have also demonstrated 4 variations on what that weighing per year might look like, including throwing out the highest year and the lowest year.
These graphs demonstrate the difference in valuations, even within a single method. It becomes clear how much impact the method you apply can have on the estimated value of the business. With so much possible variance, it is clear to see why selecting an appropriate valuation becomes such a critical part of the process.
At Maxima, our valuation process is informed by decades of experience with the market realities of buying and selling businesses. Our clear understanding of valuation process coupled with our methodology of anticipating likely buyer priorities and approach to calculations provide a realistic valuation. Contact us today to learn more about our practices and processes.
