Business Valuation Formulas? Not So Fast

Business owners are frequently in search of a simple formula to value their business.  In fact, when we do initial consultations with business owners it’s a topic that comes up extremely frequently – usually either “what formulas will you use to value my business?” or “is there a simple formula to value my business?”

Like many things in life, the answer ultimately boils down to “it depends.”

General Business Valuation Formulas

In general when people talk about “valuation formulas” they mean “shortcuts.” And those will typically come in the form of what we call “multiples.”  Multiples will express a relationship between a financial metric of the company (earnings, gross profit, or revenues), and an expected price.

For the most part the preference is to relate purchase price to earnings (EBITDA, net profit, net income, etc) vs. revenues.  Why?  Because as a buyer (or business owner), the chief concern is not creating a business that produces a large revenue number, but rather a large profit stream.

Magic Bullet?

Where we really run into trouble is owners looking for a one-size-fits-all formula.  They simply don’t exist.  Different types of businesses have different characteristics- and those characteristics are what set formulas for one business apart from the next.

Let’s look at an example: let’s compare an insurance agency to a retail store.  (First thing you are thinking is “why on earth would you compare those two?”  Exactly!  We wouldn’t – they are different and can’t possibly have the same formula.  But will persist nonetheless to prove out point…)

  • Insurance Agency Characteristics – they have a large number of clients, revenues are not concentrated into a small number of accounts, they have high EBITDA margins (and hence any swings in revenue aren’t felt as accutely on the earnings line), and they have a very high repeatability rate in their client base.
  • Retail Store Characteristis – client base is dependent on foot traffic, product is dependent on discretionary spending, low EBITDA margins, no recurring revenue base.

From a formula perspective, we might expect that the agency would transact in the 4-6x EBITDA range.  The store?  1-3x perhaps.  So there could conceivably be a 600% error involved in applying the wrong formula based on our example.

 

The Size Effect

Further confounding the use of simple multiples is the impact that size has on the value of a business.  Generally speaking, businesses that are large transact at higher relative valuations.  There are a number of reasons for this:

  • Larger businesses attract larger buyers, who are better financed and hence can “afford” a higher valuation
  • If the acquirer is a public company, by paying a “multiple” less than what their stock trades at creates instant value (example: if a stock is trading at 10x and we buy a company for 7x, those acquired earnings now have 3x extra value when subsumed into the acquiror
  • Larger businesses have gotten big for a reason – typically competetive advantages that aren’t present in smaller peers

Given that buyers are valuing for both size AND type of business, the use of a simple formula has just gotten more complicated yet again.

Take Aways

When understanding the value of a business, there is no simple, one-size-fits-all approach.  We need to understand the characteristics of a business – type, industry , location – to get a handle on likely valuation range.  From there, we need to look at that particular business and its associated risk profile.  While it’s nice to think there is an easy formula for everything, that’s just not the case.

 

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