If you own a company, you have heard several different ways to calculate its value. Some more common rule of thumb approaches are Sales price to EBITDA (Earnings before interest, taxes, depreciation and amortization), Sales price to Owner’s cash flow (OCF)/Seller’s discretionary earnings (SDE), Sales price to Revenue, Sales price to Book Value of Equity or Sales price to Earnings. Depending on your industry, a certain rule of thumb might be more applicable than another:

• Sales price to Revenue (ex. Software as a Service/SAAS)
• Sales price to Tangible Book Value of Equity (ex. Bank)
• Sales price to Earnings (ex. Public Companies)

These high-level approaches help sellers and buyers determine a general range of value for an investment using only a few inputs. This is also why they are referred to as rules of thumb because, without additional validation of the inputs, the value could be significantly different.

Shortcomings of Rules of Thumb Approaches

For example, a company’s EBITDA. In theory, this should be straightforward by adding back interest, taxes, depreciation, and amortization to the earnings. However, what if the owner owned the building the company rented and wasn’t charging a fair market rent (up or down)? This would overstate or understate the earnings, thus impacting value.

Other common addbacks would be the owner’s compensation, benefits, and other discretionary expenses. If the owner is planning on leaving, then a discussion should be had to determine the impact/risk to the future revenue/earnings. In addition, what are the fair market salary and benefits to replace the roles and responsibilities that the owner is performing for now? This topic comes up a lot in negotiations when a company is looking to sell. Therefore, it is common to review salaries, benefits, insurance, rent, and other potential non-recurring expenses/income before applying the multiple.

After you have established the underlying inputs, the multiple represents the risk. The higher the risk, the lower the value. When using EBITDA to calculate value, the “multiple” can be generically described as the inverse of the rate of return an investor would need from the investment to justify the risk they are acquiring. If an investor would expect a 20% return on their investment, the multiple would be 1/.20 (20%), which equals a 5x multiple. However, if the investor, after some due diligence, determines the risk to the future business is lower than they initially anticipated, they might be willing to pay a little more. 

Partner with Lutz M&A

Rules of thumb are a cheap and easy way to establish a sales price for management planning. However, if you are planning on buying, selling, or transferring ownership, it would be worthwhile to have an advisor, such as Lutz M&A, to help with calculating the underlying inputs to match potential ongoing risks to the company. 

For information about earnings multiples for small businesses, valuations, and other merger and acquisition services, please visit our website or contact Lutz today.