Valuation Method Examples

Note: The following examples and supporting information has been excerpted from the 13th edition of Tom West's book the 2003 Business Reference Guide, published by Business Brokerage Press.

Multiple of Discretionary Earnings Method

The reason for the name is that the method is based on the total cash flow of the owner, including salary, benefits, depreciation -- all items that are benefits to the owner, or discretionary items. All of this is then added to the profit of the business to arrive at a grand total of the owner's cash flow. There are actual and real expenses that are necessary to the operation of the business such as: rent, utilities, labor, etc. There are expenses that the owner has control over such as: auto expense, salary (his or hers), owner benefits and the like. Then there is depreciation and amortization that are non-cash items.

When this method is used as a method for valuing small businesses and companies, it is referred to the Multiple of Discretionary Earnings Method. When it is referred to by another name (Seller's Discretionary Cash, Owner's Cash Flow, Owner's Benefit, etc.), it is a less formal method and is used for pricing or arriving at an information estimation price.

Jeff Jones has said, in the 2nd Edition of the Handbook of Business Valuation, edited by Tom West and Jeff Jones, (John Wiley & Sons, 1999), "Perhaps better than any other appraisal method, the Multiple of Discretionary Earnings Method strives to measure the economic and lifestyle characteristics perceived by those who buy and serve as owner/operators of small to midsize businesses." Jeff goes on to say, "The Multiple of Discretionary Earnings Method overcomes the shortcomings of the old 'rule of thumb.' This method has practicality that buyers and sellers of small to midsize businesses can understand. The vast majority of those who acquire small to midsize businesses are corporate executives, engineers, skilled blue-collar workers and immigrants. These people often think in terms of lifestyle and income to support their families. They look at the total discretionary earnings to see if it is sufficient to pay all the operating expenses of the business, carry debt structure necessary to buy and/or operate the business, and provide a livable wage. This is a different thought process from professional investors who buy ownership interests in large publicly traded businesses motivated more by return on investment than by lifestyle considerations."

Discretionary Cash (Method Two)

This is a more formal alternative than the others. It is one used by Jeff Jones of Certified Business Appraisers of Houston, TX. He is a well-known business appraiser and, in addition to being the co-editor of the Handbook of Business Valuation, both the 1st and 2nd Editions, published by John Wiley & Sons, contributed the article on the Discretionary Earnings method. Jeff uses an analysis table where ten factors are weighted and a multiplier is then calculated. Each factor is rated on a scale of 0 to 3. Jeff's method is based on the premise that a business will not sell for more than three times earnings.

Here is a completed example of Method Two:

Pricing Analysis of BBP Fast Food

Price Based on Preparer-Computed Multiple

Price Based on Rule of Thumb

Key Factor Analysis for BBP Fast Food

Notes

1. Owner's salary is $30,000 per year
2. Pays spouse for bookkeeping/banking
3. Includes deductions for owner
4. Owner's benefits
5. Includes owner disability policy - $4000
6. Fast Food Convention
7. Includes ins and gas
8. Will be paid when sold

Assets/Based Method

Jeff goes on to say, "An assets based method not mentioned in your book, but is now being taught as a part of the BV series of IBBA courses is known as the Asset Accumulation Method. Here are the steps:

1. Prepare a reconstructed balance sheet showing the reported assets and liabilities.
2. Add any assets needed to operate the business, but not shown on the reported balance sheet.
3. Adjust the balance sheet to reflect Non-Operating Assets and Liabilities.
4. Determine the market value of the tangible assets and liabilities to be included in a sale. Sources of this information can be found be contacting used equipment dealers and/or auctioneers.

This method is best used for real estate holding companies or asset heavy companies with earnings that do not support a value higher than the tangible assets. The latter may indicate that the company may only be worth the liquidation value of its tangible assets. This method is often used even with profitable companies to represent the low end of the range of indications of value, and sets the hurdle that valuation methods based on earnings must overcome to show proof of goodwill value."

Appraisers and Analysis Table

Excerpted with permission. Copyright © 2003 Business Brokerage Press. All rights reserved.

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