Multiples of Earnings Business Valuation Method
The valuation of a business is the process of determining the current worth of a business, using objective measures, and evaluating all aspects of the business. A business valuation might include an analysis of the company's management, its capital structure, its future earnings prospects, or the market value of its assets.
Businesses are valued for different reasons - someone wants to buy the business, or you want to sell your business, or you want to establish a value in case you lose your business in a disaster.
There are several ways to value a business:
What Does the Term "Multiples" Mean?
The term "multiples" has a specific meaning in business finance. A multiple is a way to measure one element of the financial status of a company by comparing two metrics (relevant numbers). Because businesses are different, multiples and ratios are used for comparisons between unlike companies, rather than using definite numbers.
A multiple is a fraction in which the top number (the numerator) is larger than the bottom number (the denominator). One common multiple is price/earnings ratio, which measures stock price to earnings. P/E ratio tells what the market (stock buyers) are willing to pay for the company's earnings. A higher ratio means people will pay more.
What are Earnings?
The earnings (income or profit) of a business are used to value a business in this multiples method. By the way, the terms earnings, income, and profit have essentially the same meaning.
When someone is buying a business, the first thing they want to know is, "How profitable is it?" "How much money does it make?
You can look at earnings in different ways, depending on what you include. Do you deduct taxes? Do you include non-sales income like interest income? In most cases, EBIT (earnings before interest and taxes) is the measure used in this measurement.
Sometimes earnings are calculated as EBITDA (Earnings before interest, taxes, depreciation, and amortization).
Sometimes the earnings are adjusted to take out income taxes, non-recurring income and expenses, non-operating income and expenses, depreciation and amortization, interest expense or interest income, owner compensation.
Valuing a Business With Multiples of Earnings
In most cases, EBIT (earnings before interest and taxes) is the measure used for the earnings number. But what is the bottom number, the multiple? Let's say the multiple is 2. If the earnings of the business are $900,000, the multiples of earnings calculation mean the business may be valued for sale at $1,800,000.
There are some national standards, depending on industry type and business size. Buyers, guided by appraisers and business valuation experts, use rules of thumb to value businesses based on multiples of business earnings. Bizbuysell says,
nationally the average business sells for around 0.6 times its annual revenue.
But many other factors come into play. For example, a buyer might pay 3 or 4 times earnings if a business has market leadership and a strong management.
The Bottom Line on Using Multiples of Earnings to Value a Business
Before you accept the use of the multiples of earnings method as a valuation method for a business you are considering buying, be sure you know:
- What is included and not included in earnings?
- What is the multiplier in the multiples of earnings equation and why was it used?
- What is the average or most common earnings multiple in other businesses in this industry?
- What factors besides multiples of earnings should be taken into account in this business valuation?