By William Bruce
Updated April 26, 2019
As a business broker and appraiser, I’m often asked how to value a business. The valuation of a privately held business is not an exact science but there are guidelines and rules-of-thumb that can be used for a close approximation of value.
Certain situations require a formal business appraisal including the larger merger-acquisition transactions, SBA loan applications, management performance tracking, estate planning, divorce — or the most dreaded of all — IRS issues. After all, a professional, fully documented appraisal certainly takes the guesswork out of the situation.
However, what we’re talking about here is not a formal appraisal but rather the informal methods of quickly approximating the value of a business entity. All of the guidelines we’ll quote are averages derived from hundreds of completed transactions reported to national databases.
There are two methods of quickly approximating value: (1) applying a multiple to the discretionary earnings of the business and (2) applying a percentage to the annual gross revenue of the business.
The most accurate of the two rules of thumb seeks to approximate the value of a business by applying a multiple to the company’s discretionary earnings. What are discretionary earnings? It is NOT the profit or loss that you show Uncle Sam on your tax return. To put it delicately, almost all business owners run some expenses through the business that are — a’hem — not absolutely necessary to the operation of the business.
Discretionary earnings are the total cash that the business generates in a year that is available to the owner after deductions for only the necessary operating expenses. Another way to define discretionary earnings is that it is the “total owner’s benefit” derived from owning the business, regardless of how the owner takes the money out of the business. It is the amount of cash left over after necessary expenses that is available for (1) owner’s remuneration, (2) return on investment and (3) debt service, if any. Here’s another article going into greater detail on the subject.
Almost all privately held businesses will appraise for somewhere between one to five times discretionary earnings. Exactly where in this range that a specific business falls depends on the type of business.
From the database of completed transactions, we know that an air-conditioning/heating contractor, for example, is valued at approximately 2 to 3.5 times discretionary earnings. A retail gift shop is worth about 2.3 to 3.5 times discretionary earnings. Home health care is 2 to 4 times; dry cleaners are 2.5 to 3. Wholesale distributors, in general, are valued at between 2.75 to 3.75 times discretionary earnings. Where within these ranges by category a particular business falls depends on many factors considered by valuation experts.
A less accurate method of estimating the value of a business is to apply a percentage to the company’s annual gross revenue. For example, a full-service restaurant with a liquor license will be worth about 30% annual gross revenue if it’s earning the average bottom line profit for its peer group.
As other examples, auto service shops will be valued at 25 to 30 percent of annual gross revenue and, astoundingly, profitable radio stations will be valued at anywhere from 1.5 to 6 times annual gross revenue.
None of these appraisal guidelines include the value of any real estate or inventory on hand. If the business owns real estate, the value of the realty should be added to the guideline result. And inventory, at cost, should also be added to obtain the total estimated value of the business.
However, you as the owner, seller or buyer of the business are the final arbiter of what the business is worth to you. Remember, these guidelines are only averages. And the guidelines certainly don’t take into account any special considerations or any future plans that an owner might have for the business. What a particular business might be worth to you may be more or less than it’s worth to the next person who looks at it.
One final observation: Interestingly, there is very little geographic deviation in the value of businesses. A gift shop in Alabama with similar financial performance is worth about the same as one in California.
Here are additional articles that might be of interest: How to Analyze a Business You’re Considering Buying, How to Make a Written Offer to Buy a Business and How to Handle the Due Diligence Investigation When Buying a Business.
If you have questions about business valuation, please contact me at (251) 990-5934 or Will@WilliamBruce.org. In addition to estimates of value using rule-of-thumb guidelines, we also produce written, fully documented business appraisals for banks, business buyers and sellers, minority / majority partners and others.
In our practice, we also provide nationwide consulting services to individuals who are considering buying or selling a privately held business.
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William Bruce is a business broker, an Accredited Business Intermediary and a business appraiser. He currently serves as president of the American Business Brokers Association. His practice includes consultations nationally on matters involving business valuations and transfers. He may be reached at (251) 990-5934 or by email at Will@WilliamBruce.org.
(C) Copyright William Bruce. All rights reserved.
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