Although there are many different ways to value small businesses, I consider the core method for valuing small businesses, especially very small businesses, to be “multiple of earnings.”
In looking at multiple of earnings, you first want to ask: Are we talking pretax earnings, which some people say aren’t technically earnings at all, or after-tax earnings? You can use either, but if you use after tax you need to check what your tax rate will be, not what the seller’s was.
Next, you need to decide which year of earnings to base the valuation on. Often, sellers will base their asking price on a multiple of the current year earnings, even though the second half of the year has yet to happen.
Then you want to think about earnings history. It is not unusual to see businesses for sale after having a huge jump in profits the prior year. If this is the case, you need to think about how sustainable the jump in earnings is. If earnings are erratic, then erratic earnings suggest higher risk, which make the company worth less.
Although I emphasize that every business situation is different, and that exogenous factors (such as what is going on the stock market and the outlook for the economy as a whole) can have an impact, I am going to stick my neck out and offer some simple business valuation guidelines.
The following guidelines are assuming you are running a very small business, such as $100,000 to $2 million in sales, with a modest level of recent and expected future growth, such as mid–single digit, and no looming major problems (such as a new competitor chopping into the market share). Finally, these multiples are based on pretax profits.
Bob Adams’s Simple Valuation Guidelines
- An extremely well-established and steady business with a rock-solid market position, whose continued earnings will not be dependent upon a strong management team: a multiple of 8 to 10 times current profits.
- An established business with a good market position, with some competitive pressures and some swings in earnings, requiring continual management attention: a multiple of five to seven times current profits.
- An established business with no significant competitive advantages, stiff competition, few hard assets, and heavy dependency upon management’s skills for success: a multiple of two to four times current profits.
- A small, personal service business where the new owner will be the only, or one of the only, professional service providers: a multiple of one times current profits.
For larger small businesses, such as middle-market companies with sales of several million dollars up to several hundred million dollars, valuation may be more commonly thought of in terms of a multiple of EBITDA (earnings before interest, taxes, depreciation, and amortization). For these companies, assuming modest growth of low to high single digits, a common fair valuation range is five to seven times EBITDA.