How to Value a Business
To learn how to value a business, it’s important to understand the two definitions of “earnings” to which multiples are applied:
- EBITDA: an acronym for Earnings Before Interest Taxes Depreciation and Amortization.
- SDE: an acronym Seller’s Discretionary Earnings.
Although there is some crossover as to which earnings numbers are used to value a business, in general, larger businesses (with business values in excess of $5,000,000) are valued using EBITDA, while smaller businesses are valued using Seller’s Discretionary Earnings (SDE).
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How to Value a Business Using Multiples of Earnings
As the acronym suggests, if you are using financial statements as the source documents, EBITDA is calculated as Earnings + Interest + Taxes + Depreciation + Amortization. Taxes refers to income taxes (only). If the source of the financial information is your tax return, the income is already before taxes, so federal income taxes are not added back.
To compute SDE, the value of all owner’s compensation, including perks, is added to EBITDA. Therefore, Seller’s Discretionary Earnings (SDE) equals EBITDA + owners compensation + other owner benefits.
To value a business accurately, there are other types of adjustments that may be required to “normalize” earnings . For instance, it’s always important to adjust the facility occupancy cost to fair market value. This comes into play most often when the business owner also owns the company’s facility and the business is not paying fair market rent. There are many other types of adjustments that might be required which are beyond the scope of this article. This article: “Add Backs for Business Valuation” (from the How to Plan and Sell a Business website, of which I am the author) discusses other types of adjustments that may be required.
Multiples of Earnings
To value a business, an appropriate multiple is applied to the earnings number of EBITDA or SDE. Because Seller’s Discretionary Earnings (SDE) is a larger number than EBITDA by definition (because it includes the owner’s earnings), SDE multiples are always less than EBITDA multiples. For both SDE and EBITDA, the appropriate multiple to be applied increases as earnings increase. SDE multiples are typically in the 1.0 – 4.0 range and EBITDA multiples are typically in the 3.5 – 7.0 range. For instance, the appropriate multiple for a business with $500,000 of SDE might be 4.0, thus yielding a business value of $2,000,000 ($500,000 x 4.0 = $2,000,000). The EBITDA calculation for that same business might be $400,000. At a multiple of 5.0 for EBITDA, the business value computes to the same $2,000,000.
To see a chart of SDE multiples displayed by the level of earnings, read this article from the How to Plan and Sell a Business (HPSB) website: “How Small Businesses Are Valued Based on Seller’s Discretionary Earnings (SDE”). Also on the HPSB website, you can find a chart of EBITDA multiples displayed by the level of earnings in this article: “EBITDA Multiples by Industry”.
How to Value a Business- Resources on the HPSB Website
We encourage you to visit the How to Plan and Sell a Business website and subscribe to the How to Sell a Business email newsletter, which is free and is delivered every other week on Tuesday mornings. There’s a total of 90 email newsletters. All are on the website as well, but they are truncated at about 75% length if you are not an email newsletter subscriber.
Following is a description of the resources available on the How to Plan and Sell a Business website related to how to value a business and other business valuation issues.
To determine how to value a business, read these six sequential newsletters:
- Issue #6 – How Small Businesses Are Valued Based on Seller’s Discretionary Earnings
- Issue #7 – SDE vs. EBITDA vs. Adjusted EBITDA Leads to Multiples Confusion
- Issue #8 – An Example of SDE vs. EBITDA vs. Adjusted EBITDA
- Issue #9 – A Seller’s Discretionary Earnings (SDE) Worksheet
- Issue #10 – SDE and Business Valuation Variations amongst Sellers, Buyers and Lenders
- Issue #11 – The Importance of Setting a Realistic Offering Price
The following newsletter articles also address important aspects of business valuations:
- Issue #53 – Purposes of a Business Valuation
- Issue #54 – About Professional Business Valuations
- Issue #60 – Owners with Unrealistic Price Expectations
In addition to the newsletter articles above, here are 11 other articles that address specific topics of how to value a business:
- EBITDA Multiples by Industry – contains a chart of the appropriate EBITDA multiples by earnings level for eleven categories of industry types.
- EBITDA Example – provides an example of the calculation of EBITDA.
- Adjusted EBITDA Calculation – provides an example of the normalization of excess owner’s compensation and of an adjustment for facility rent.
- Add Backs for Business Valuation – provides examples of other types of add backs that should be considered when normalizing earnings.
- Earnings Multiples for Small Business – provides more information on EBITDA, Adjusted EBITDA, and Seller’s Discretionary Earnings (SDE), including examples.
- How to Valuate a Company – discusses alternate methods of valuation other than multiples of earnings, such as rules of thumb, asset valuations and professional business valuation.
- How to Value a Small Business For Sale – provides a basic explanation of how to value a small business.
- What Is My Company Worth? – provides an overview of why it’s important to ask that question, with a brief explanation of the methods to value a business.
- How Much Is a Business Worth? For Sellers, Buyer and Investors – provides insights for sellers, buyers and investors on the importance of understanding how to value a business.
- How Do I Value a Business? – suggests that many business brokers will provide a no charge, no obligation evaluation of a business, including a broker’s opinion of value.
- How to Value Goodwill When Selling a Business – explains how goodwill is calculated and provides an example.
Note #1: There are multiple business valuation methods. Valuing a business can depend on many factors. Multiples of earnings is only one method used by professional business valuation firms. But using earnings multiples is the most common method used by business brokers.
Note #2: Other than the simplified calculations of EBITDA shown above, there are many other types of adjustments required to normalize or recast financial statements before an earnings multiple is applied. It is important to read the details and examples of EBITDA adjustments in the How to Plan and Sell a Business newsletters to gain a better understanding.