I have been selling private businesses for more than 25 years in the UK, Australia and South Africa, and have found that nine times out of ten it is the multiple of earnings method that can best be used to give the quickest and most useful approximation for the vast majority of businesses.
Clearly, if your business is loss-making or its value relates almost entirely, say, to the ownership of a property or other asset rather than from profits derived from trading, then other methods could be more appropriate.
But if your business displays the following characteristics, and you are prepared to sell a majority stake for an up-front payment (i.e. without deferred consideration), then it should be possible to provide a rough indication of value using the multiple of earnings valuation methodology.
It requires the following:
- Your business has been trading profitably for three or more years.
- It has been making ‘normalised’ profits broadly within the ‘standard range’ for your industry.
- Your business is forecast to carry on trading in broadly the same manner, and with the same level of profitability.
So how does this work?
This rule of thumb is not as straightforward as people think. As the valuation name implies, there are two elements to the methodology, and both must be assessed correctly to give the most accurate ball-park figure. But this shouldn’t take too long.
The easiest way to determine the earnings to which the multiple must be applied is simply to take the most recent after-tax profits from your audited accounts. But if you do this alone, you could be leaving serious value on the table, and you may be able to make a case for a far better number.
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Factors to consider are:
1. Where you are in your financial year
If you have a February year-end, and it is already November — you could make a case for more weight to be given to the current financial year (especially if you can support your forecasts with hard evidence) than the previous one.
2. Whether your profits have been ‘normalised’
There are often a number of expenses that, in the ordinary course of business, would not appear on your books. Perhaps you pay yourself way above market rates. Perhaps there was a once-off expense that won’t be repeated. Perhaps your spouse manages the switchboard but is paid as much as a director.
3. Your profit trend
If you have been growing steadily, but have now taken demonstrable steps to rapidly improve your rate of growth (through new products or by entering new markets), you can make a case that a buyer should give more weight to your future forecasts than your historical performance.
The key number to derive here is the future net maintainable earnings (FNME) of your business. This involves looking both backwards and forwards in time, and then applying a weighting to each year based on its relevance to the level of earnings you believe your current business could maintain.
Once you have determined your FNME, having taken consideration of the factors above, you need to come up with a multiple of profit after tax per year to apply to this.
In its simplest form, a private-company multiple is simply a discount to the average listed price earnings (PE) ratio for your sector. Discounts take account of such factors as the size of your business, its trading history, its level of diversification, the strength of its brand, the liquidity of the shares, etc.
A valuation practitioner will attempt to quantify the discount that should apply to each of these factors — but in reality private-company multiples tend to fall into a standard range.
This varies over time, but in South Africa over the past five years, and for businesses broadly in the R20 million to R250 million turnover band, this has tended to be in the five to seven range, as long as you have a relatively generic trading business.
How does this work in practice?
I recently did a ‘rule of thumb’ relative valuation of two media companies — both operating in the same industry, but with different characteristics in terms of years trading, size, location and profitability.
The smaller of the two companies, based in Cape Town, had been trading for six years, and although it had grown strongly to some R40 million in turnover, it had now reached a plateau as it struggled to grow to the next level.
The significantly larger company had been operating for more than 20 years, and although based in Johannesburg, also had significant revenue streams from overseas. Despite its size and maturity, it exhibited a lower profit before tax percentage than its smaller counterpart, and had a strong reliance on one or two large customers.
With the trading histories of both companies available from the audited accounts, and fairly detailed three-year forecasts with supporting assumptions readily to hand, I was able to derive an FNME for each company by applying weightings to each of the past three and forthcoming three years’ performance.
My starting point was to examine each year’s numbers, and then allocate a weighting as to how representative these were to how they might trade going forward.
Determining the multiple
The next step was to determine the multiple. A review of the listed sector in South Africa, and information on recent transactions in the media space confirmed that we were almost certainly talking in the usual five to seven range for privately-held trading companies. It was then a matter of applying differing discounts to the listed average PE for such factors as size, profitability, diversity, markets served, etc.
As expected, the larger of the two companies, despite its short-comings in terms of net margin and customer reliance, came out slightly on top. Both its relative position and years trading in the market, as well as the strength of its brand, gave it the edge.
With my rule-of-thumb analysis complete, I was able to offer a relatively narrow range of values for each company, which came out within a few percent of each of the owners’ expectations of their own, and their counterpart’s, relative value.
Although not necessarily carrying the weight of a detailed and ‘signed-off’ valuation report, this quick rule of thumb can be every bit as accurate as the more expensive and comprehensive methodologies most valuation practitioners employ. But as a swift and relatively accurate approximation, it can certainly meet the needs of many business owners.
Putting it all together
At its most simple, taking your most recent audited profit after tax and applying, say, a multiple of six will give you an immediate ball-park number for your value. But this may not be your best rule of thumb!
Apply a little more time and thought, derive an FNME that you can defend, and you can find that the value you are placing on your business could in fact be substantially higher — especially if you are growing strongly and perhaps improving margins.
Lastly, recognising such factors as your level of diversification of products and customers, the strength of your brand and the relative size of your business relative to your competitors, to name but a few, could allow you to make a case for a higher multiple — nearer to 6,5 or even 7.
So instead of, say, R10 million x 6 = R60 million – with just a little work your rule of thumb could be justifying, say, R12 million x 7 = R84 million — which is 40% higher — and definitely worth the relatively small extra effort.
Methods of valuating a business:
- An asset-based valuation plus an assessment of goodwill
- A discounted cash-flow valuation
- An industry specific ‘norm’
- A multiple of earnings valuation.