13 Oct The Basics of Valuing a Small Business
Valuing a business can be difficult and complicated. It requires following a complex set of rules, knowledge of valuation techniques, factors driving value in the industry, laws and accounting standards, and a good understanding of the subject company. However, when broken down to its simplest terms, a business valuation consists of two factors: 1) the business’s cash flow and 2) SDE multiple.
Seller’s discretionary earnings (SDE) are an integral cash flow stream for small businesses and is therefore one of the simplest ways to find the value of a company. The purpose of SDE is to measure how much money a business brings in for the person who owns it. SDE encompasses all cash flows paid to a single owner-operator, including any adjustments for the owner’s salary, discretionary expenses, and nonrecurring income/expenses.
SDE = Adjusted EBITDA + Owner Compensation (one full-time owner)
Where EBITDA = Net Earnings + Interest + Taxes + Depreciation + Amortization
The information needed for this calculation can easily be found in your business’s tax returns or income statements (internal, accountant compiled, accountant reviewed, etc.). Whether you are calculating a company’s true SDE or EBITDA, you will often need to work through normalizing adjustments. Learn more about this in our article, “Calculating Cash Flow for a Business.”
In business valuation, a multiple, also called an “industry multiplier,” is a financial tool that evaluates one metric to another to make different companies more comparable. While the SDE tells us how much money a business can be expected to earn over the course of the year, with adjustments, it doesn’t speak to the long-term value of the business. The multiple takes that into account.
Multiples are determined by business appraisers, who consider a number of risk factors including:
- Owner involvement
- Financial strength
- Transferability of revenues
- Potential business buyer pool
- Customer concentration
- Product mix
- Marketability and brand recognition
- Management depth
- Business model
- Age and value of equipment
- Industry trends
- Growth prospects
It is important to keep in mind that not all factors are applicable to each business or industry. Valzy’s database of business transactions financed by SBA lenders indicates a median multiple for small businesses across all industries to be 2.5x SDE. Using this as a starting point, we can expand the range to be between 1.5x – 4.0x SDE for small businesses (revenues less than $5 million).
As an example, let’s look at the inherit risks of a dental practice:
- Owners are usually significantly involved in the operations of the business.
- There is a high risk of attrition due to a change in ownership.
- The size of the potential buyer pool of the business is limited to only licensed dentists.
- There are very few barriers of entry for competitors.
Based on these factors, a reasonable earnings multiple for a dental practice should be 1.5x – 2.0x SDE. If the SDE of the practice is $250,000 then multiplied by the 1.5 – 2 results in a business value in the range of $375,000 to $500,000.
By breaking down your calculations into just cash flow and the SDE multiple, you can find the simplest version of your small business valuation. There can be many more factors at play that drive the value of your business. Accurately weighting the calculated values and using good judgement in making adjustments can be the biggest challenge in achieving a fair and accurate valuation. Valzy is a quick and easy business valuation application that can provide you a more accurate idea of what your business may be worth. Get started today and learn the true value of your business.