Business Valuation Blog | Understanding Buying / Selling a Company

When you're trying to get a grasp on the world of business appraisals, one term that is often tossed around is valuation multiples. In general, it involves business valuations based on the value of another business, either by similar size and market share or by income, which is then adjusted for any differences between the two businesses. But what about valuation multiples we hear about in the news for different businesses? What makes these businesses gain or lose value and how can you apply that information and insight into your own business? Here are a few real-world examples, courtesy of Market Realist, of how companies' valuation multiples actually work.

How do Valuation Multiples Work in the Real World?

Fiat Chrysler Automobiles

There are a number of different valuation multiples used in the automotive industry, but one that stands out with Fiat Chrysler is EV-to-EBITDA, or enterprise value to earnings before interest, tax, depreciation and amortization. Recent figures have shown it to be approximately 1.3x, which is half that of Ford's 2.6x and GM's 2.5x. Chrysler's figures are also lower in price to earnings and net profitability. Why? Some of it is related to perceived loss of value in their products, but the main factors include their progress on the company's debt reduction plan, expanding margins consistently and trends in domestic car sales.

Home Depot

Because Home Depot has high earnings visibility, analyzing the price to earnings valuation multiple is one of the easiest ways to look at how this company competes. Even though the housing market is still recovering, the recent slowdown in the economy and uncertainty about changes in the interest rate have lowered the company's multiple from 20.4x prior to announcing its earnings to 18.4x. At the same time, investors are still confident in the company's ability to perform, with even its lowered multiple significantly outperforming competitor Lowe's 15.6x.

McDonald's Restaurants

After McDonald's reported gains in the prior quarter, the company's multiples grew from 18.6x to 18.8x. Though this seems like a small change, it can represent millions of dollars of value that was quickly added to a company that is already mature and does not have as much room for growth as younger competitors. In other words, because McDonald's has already grown through so much of the market, its ability to grow is limited, but their value can still improve based on improved earnings.

Time Warner Media

Time Warner has a price to earnings multiple that is second only to Disney's numbers, and an EV-to-EBITDA multiple that is the highest among the industry giants. But what is their advantage that keeps the company with the high numbers? The company has continued developing original programs, is looking at a new approach to content licensing strategies in overseas markets and has made active gains in promoting its digital platform viewer numbers. These innovations have allowed the industry giant to expand even in a tight market.

As you can see, valuation multiples are a tool used to determine the valuation of a company across many industries and specialties. By knowing how they interact with real work situations, you can get a better grasp of what events will impact your business' overall value.

And of course things change quickly...so by the time you are reading this the company's earnings and possibly the earnings have changed!

As a business owner, it's easy to assume that the valuation of a company is based solely on the balance sheet or the sum of your assets instead of taking into consideration market conditions and future income. When this happens during a negotiation, it can dramatically impact how much you get out of the deal. Before you assume you know the answer to the question, "What is my business worth", take a look at what company valuation specialists look at when performing business appraisals.

What is my business worth? The answer may surprise you

Asset-Based Approach

An asset-based calculation of business value is one of the most commonly used methods by business owners, but it's also the least accurate. Many business owners will look at the depreciated value of their assets on a balance sheet as compared to their liabilities and think their business is worth the difference. Unfortunately, many businesses depreciate their capital equipment based on a standardized rate schedule developed by the IRS instead of basing the value on what the equipment is actually worth. This can create a significant difference between what a business is worth on paper versus in reality.  First, appraisals should be completed on the assets for the analysis to be accurate.  Second, if the business is profitable, more likely than not the business has created goodwill and this method does not take it into account.

Income-Based Approach

By comparison, a business appraiser will look at one of two other approaches long before they look at an asset-based approach. The first of these is an income-based approach, which calculates the value of a business based on prospective future earnings. The business value is based on a projection of income for a certain time period, which is then discounted for a business value. When a company demonstrates that it has regular growth and cash flow, the appraiser will use a capitalization of earnings method to project potential income into the future. If the company has had irregular cash flow and periods of boom and bust cycles, a discounted earnings method is used to project the income into the future, providing a current price for the expected future benefits.

Market-Based Approach

The other approach that a business appraiser may choose to take, based on the circumstances, is to look at what similar companies are selling for to determine a fair value for a business. This can be based on information available for transactions that occurred for similar businesses. For example, discretionary earnings is calculated by adjusting financial statements to calculate an adjusted EBITDA which includes the owner's compensation, which is then calculated with a multiple to determine value. Other methods look at a percentage of the company's revenue.  Statistics is used to develop multiples and percentages and they are applied to the subject business.

Now that you have a better idea of what a business appraisal specialist sees when performing  valuations, what answer do you want to the question, "What is my business worth?" By having a quality company appraisal performed by a certified business valuation specialist, you can ensure that when you leave the negotiating table, you've done everything you can to ensure you get what your business is really worth.