HOUSTON BUSINESS REVIEW

TUTORIAL ON SELLING YOUR BUSINESS: “Valuation - Earnings and Multiples” Part I
By Ralph Fain

Ralph Fain is a principal in the brokerage firm, R/Fain Group. Mr. Fain also has over 20 years of broad business experience with Fortune 500 companies. R/ Fain Group is a professional business brokerage firm which confidentially represents the interests of various sellers and buyers. Each week Mr. Fain will give tips on Business Brokering, and how to sell your business.

In our latest series of articles we have been addressing a number of subjects related to business value determination – e.g., defining exactly what you are selling in the transaction, valuation methodologies, type of sale (stock vs. asset), etc. Two key topics which require additional review are the concept of “multiples” and the definition of “earnings” and the role they play in the determination of the value and/or asking price of a business.

“Multiples” is a term which is used to help define or help create a measurement or parameter for the value of a business – i.e., 5X Net Income, 4X EBITDA, 3X SDCF, etc. The resultant product of the above multiplication is an approximation of the worth of a business when utilizing a “multiple of earnings” valuation methodology (ref HBR Sept 05 Issue No. 3 “Valuation – Part II” for additional detail). As you can readily determine, “multiples” are derived by dividing the sales price of a business by its total “earnings” – the resulting product being the company’s price to earnings ratio or “multiple”.

For example, if a company sold for $2MM and its latest annual “earnings” were $500K, the price to “earnings” multiple would be 4X “earnings”. The problem with this approach (other than the definition of “earnings” which we will address in our next article) is that it tends to be misused and misunderstood; it also tends to be a “cook book” approach and, because of its misleading simplicity and superficiality, it can lead to grossly inaccurate results (remember from earlier articles that business valuations are complex and comprehensive undertakings which should be performed by credentialed and technically proficient professionals). Additionally, reliance on “multiples” (without a thorough understanding of how derived) can engender a false sense of empowerment/knowledge in people of varying experience levels.

These types of buyers are likely to be very opinionated when it comes to not wanting to buy a company for more than 2X earnings; likewise, sellers of this ilk will not want to sell for anything less than 5 X earnings. Both are operating from a position of insufficient understanding; neither knows how the standard “multiples” were derived historically (did the sales figures include or exclude amounts for real estate, inventory, FF&E, accounts receivable, etc?) nor do they know which type of “earnings” figure was utilized in the historical calculations, the product of which they are now using as their barometer for evaluating prospects and businesses. Consequently, both types can make significant errors when it comes to the pricing and valuation of a business and, resultantly, will pass up perfectly legitimate (and attractive) buying and selling opportunities.

One of our latest articles (ref HBR Sept 05 issue No. 1, “Valuation – Part I”) dealt with defining exactly what is for sale when selling a business; our next article will discuss and define the different types of “earnings” used in calculating “multiples”. Please note that there are a multitude of “earnings” figures which can be utilized but we will concentrate on the 4 or 5 most common (frequently used) ones. We will also discuss the significant impact “earnings” and “multiples” can have on a purchase/sales price; additionally, we will also provide detailed calculations for you in order to illustrate this effect.

See you next week in this same space for our next article. As always, should you have any questions or require additional information please feel free to contact the R/ Fain Group at 832-646-0832 or via our web site.