Wednesday, March 2, 2011

Why do Business Valuations Vary for the Same Business?

Business valuations are completed for a long list of reasons. The results of the valuation will vary significantly based on the purpose of the valuation. The purpose will determine level of detail, complexity of analysis, degree of due diligence, and the amount of legal reps and warranties required etc. In the market place most times you will hear a business value described as 2.5X normalized income before tax, or 5X net profit after tax, or 1X gross revenues, etc. While you develop a sense for what a business might be worth, you must also develop an understanding of what type of valuation process makes the most sense.

For simplicity we will demonstrate a simple valuation based solely on normalized Earnings Before Interest Taxes Depreciation & Amortization or EBITDA. This is not meant to address the multiple variations and calculations a Certified Business Valuator (CBV) would process and calculate. This model simply demonstrates the impact of the most common rule of thumb/snap shot estimate of value: EBITDA times some multiple.

For this model we take the last 5 years Total Sales and EBITDA:

When you only look at the last years EBITDA (2010) you can see the results of the multipliers.

This method would be the simplest to calculate however when you only look at one year you have the greatest risk of misrepresenting the real value of the business. For example: if the last year was the best year ever, you are most likely over valuing the business. If the last year was the worst year ever, you are most likely under valuing the business.

You will develop a better sense of value by applying some form of weighted average for a period of time. Our chart makes use of 5 years however you can use as many years as you like. We have also demonstrated 4 variations on what that weighing per year might look like including throwing out the highest year and the lowest year.

When you look at the graphs demonstrating the difference in valuations, you see how much impact the method you apply can have on the estimated value of the business. With this variance you develop a sense for why the appropriate valuation becomes such a critical part of the process.