Business valuation is a vital part of the selling process. Just like a business plan is the foundation of operating a successful business, a valuation is the foundation of successfully selling a business. For a business sales strategy to be effective, the valuation needs to be accurate and verifiable through a logical, analytical process. The valuation must include a firm grasp of the business’s fundamentals and broader market trends.
Having a professional by your side is key. Competent advisors know the methods to accurately value your business, but also know how to communicate critical information to potential buyers to maximize a company’s value.
There are two critical components to virtually every business valuation that a professional advisor will analyze. First, the advisor analyzes and articulates the sustainable performance that a business has demonstrated. The most accurate and broadly accepted measure of performance for small and lower mid-market deals is seller discretionary earnings (SDE). Second, the advisor performs a comprehensive market analysis to determine a probable market value based on comparable transactions.
Seller Discretionary Earnings Analysis (SDE)
What are the seller’s discretionary earnings (SDE)?
In short, SDE is the free cash flows to the owner of a business. Standard profit and loss statements report a company’s net income, but net income is not the full picture of how much cash the owners receive. Net income includes non-cash expenses (such as depreciation), one-time or non-recurring expenses (like legal fees), and expenses that directly benefit the owner (for tax purposes). A professional advisor comprehensively reviews company financial statements to determine the sustainable free cash flows that a company produces and reconciles SDE to net income.
After analyzing company financials and calculating SDE, a professional advisor determines an estimated sustainable amount of SDE. Sustainable SDE includes trend analysis, current year performance, company margins, macro and micro industry trends, and other factors that may be specific to each company.
Comparable Market Transaction Analysis
Professional advisors purchase access to databases that catalog private and public business sales. Through comprehensive analysis, an advisor can isolate comparable market sales that are most relevant to each client company. While there are many factors to consider, there are two primary points of comparison that an advisor must consider: (1) Industry and (2) Scale.
Different industries have different factors that are key to each valuation. A manufacturing company’s value, for example, will rely heavily on margins and scalability while an online swap and sell relies more heavily on volume. The most relevant factors are different across industries because revenue and profit generating activities are different for different types of businesses. A professional advisor understands these nuances and can articulate the most relevant factors in generating an estimate of value.
Scale is the second critical factor in using comparable market transactions for valuation. Smaller companies are likely to have different cost structures than larger companies. Those different cost structures have important implications for company valuation. As an example, at certain volume levels, certain fixed costs are likely to increase (like adding more equipment), while other costs are likely to decrease (volume discounts on inventory). A professional advisor understands scale in the valuation and also anticipates how costs may change if a company were to grow.
Once an advisor identifies similar market transactions, he or she can approximate multiples that are most commonly observed in the M&A market. While the comparable transactions do not determine value, they provide an important point of reference and a likely range of multiples (usually between 2 and 4 times SDE).
Estimate of Value
After the advisor determines the company’s sustainable level of SDE and the most relevant market comparable transactions, he or she will make adjustments based on niche, location, and growth potential. Certain companies will demand “above average” multiples while others may not be able to do so.
The final estimate of value applies the most relevant multiple to the estimated sustainable SDE.
Greg Martin, PhD is an M&A advisor and expert financial consultant. He can provide an accurate, industry specific business valuation of your company. He is more than happy to discuss your particular needs.
Contact Centurion 7 today to obtain a professional valuation of your business!