HOUSTON BUSINESS REVIEW

TUTORIAL ON SELLING YOUR BUSINESS: “Valuation - Earnings and Multiples” Part II
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 last article we discussed the concept of “multiples” and the care and caution which must be exercised in their utilization. As we noted in that article, industry rules of thumb and “cookbook” formulas tend to be broad and simplistic and sole reliance upon same for business valuations can lead to costly mistakes.

As an example, consider the following:

Car franchises/dealerships used to sell for net worth (assets minus liabilities) plus 1 to 3 times “earnings”. According to that old rule of thumb, a dealership with a net worth of $6MM and earnings before taxes of $1,000,000 would be worth somewhere between $7.0MM and $9.0MM. That is a $2MM difference that the seller may not receive if he relies only on industry rules of thumb for valuation purposes; likewise, it is $2MM that a buyer may overpay for the same reason.

Not only must care and caution be exercised in the utilization of “multiples” for valuation purposes but they must also be exercised in the derivation of the multiple - i.e., the type of “earnings” figure to be used must be clearly defined. As you may recall from our last article, there are a multitude of “earnings” figures currently used but we will concentrate our discussion today on the 3 or 4 most common (frequently used) ones. Below please find a brief explanation of accounting terminology as well as the definitions and derivations or the different types of earnings used in the calculation of multiples.

A company’s costs generally fall into two groups – cost of goods sold and cost of operations. The first relates to all the costs/expenses of directly producing the goods or services matched to the revenues (sales) produced by these costs; the second includes all other costs/expenses not directly associated with the production of revenue – i.e., selling, general and administrative expenses.

Subtracting both of these costs/expenses from revenue or sales gives you Operating Profit or Operating Income. Various special expenses (e.g., interest expense) and special forms of income (e.g., interest income) are then subtracted and added to/from Operating Income to arrive at Net Income Before Taxes. After deducting state and federal taxes, one arrives at Net Income (reference the below depiction for an illustrative example).

	Revenue/Sales				$2,500,000
	Cost of Goods Sold   (1)			 1,200,000
	Gross Profit				$1,300,000
	Operating Expenses
	  Selling, General and Administrative (2)	   850,000
	Net Operating Income			$  450,000
	Interest Expense				    50,000
	Net Income Before Taxes			$  400,000
	Taxes – State and Federal			   100,000
	Net Income				$  300,000

(1)	Includes depreciation of $50,000; one time non-recurring charge of $40,000.
(2)	Includes amortization of $20,000; owner’s salary/benefits of $150,000; owner’s “perks” of $20,000.

Net income					$300,000

Add back:  	Interest			  	  50,000
		Taxes			  	 100,000

EBIT (Earnings Before Interest and Taxes)		$450,000

Add back:	        Depreciation		  	  50,000
		Amortization		  	  20,000

EBITDA						$520,000

Add back:	        Owner’s Salary/Benefits	 	 120,000
		Owner’s “perks”		  	  20,000
		One time non-recurring charges	  40,000

SDCF (Seller’s Discretionary Cash Flow)		$700,000