HOUSTON BUSINESS REVIEW

TUTORIAL ON SELLING YOUR BUSINESS: “Valuation - Earnings and Multiples” Part III
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.

As discussed in our last article, there are 3 or 4 common “earnings” figures which are utilized in “multiples” and business valuations. These are Net income, EBIT (Earnings Before Interest and Taxes), EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) and SDCF (Seller’s Discretionary Cash Flow) or ODCF (Owner’s Discretionary Cash Flow) – ref HBR Oct 05 Issue No. 3, “Valuation – Earnings and Multiples – Part II).

Due to the significant impact on a company’s valuation (and hence sales/purchase price), it is critical that sellers and buyers of businesses understand which “earnings” figure is utilized when someone tells you “the business is priced at only @ 2.5 X earnings” – see also Note (1) below. The difference between 2.5 X earnings and 2.5 X “earnings” can be a significant amount as the following example illustrates.

Example: Company has Net Income of $200,000/yr (remember Net Income is the net profit after deducting all expenses of the business including owner’s salary, interest expense, taxes, etc – ref Oct 05 Issue No. 3 above for additional detail. Owner’s salary/ benefits/”perks” were $250,000, depreciation was $60,000, amortization was $30,000, interest was $60,000, taxes were $90,000 and there was a one time non-recurring expense of $70,000 (moving expense). The owner of the business had heard from his associates that the industry valuation standard for companies similar to his was 2.5 X “earnings” and thus he wanted to establish his company’s sales price according to this industry standard or rule of thumb. Note the impact on the valuation (sales price) of the different “earnings” figures as a result of the application of the industry standard.

		Earnings								Calculated
	Type			Amount			Multiple			Sales Price

Net Income			200,000			    2.5			  500,000
    +  Interest			 60,000						
    +  Taxes			 90,000
EBIT				350,000			    2.5			  875,000
    +  Depreciation		 60,000
    +  Amortization		 30,000		
EBITDA				440,000			    2.5			1,100,000
    +  Owner’s Salary/et al		250,000
    +  One time non-recurring chg.	 70,000
SDCF				760,000			    2.5			1,900,000