How to benchmark the value of a business
Of course, every business is unique and therefore there are no formulaic one-size-fits-all models to determine value, and an appraiser utilizes his or her professional judgment, experience, and analysis to reach a valuation conclusion.
But what if you want a general ballpark value of what a specific business is worth? One way to determine this is to look at how much others have paid for similar businesses relative to different earnings measures.
Let’s consider three financial metrics:
- Revenues: The total amount of money that is brought into a company by its business activities. Sometimes referred to as the “top line” and is prior to any expense deduction, including materials.
- EBITDA: An acronym for earnings before interest, taxes, depreciation, and amortization. These are the earnings of the business before the aforementioned expenses.
- Seller’s discretionary earnings (SDE): One measure of earnings to an owner/operator of a business. This figure is calculated by adding owner’s salary to EBITDA.
When benchmarking the value of a business…
we compare the above earnings measures to selling prices of a similar business to create a ratio, also known as a business selling price multiple or valuation multiple.
Selling price to revenue (or selling price/revenue) is the selling price of the sold business divided by that business’s revenue. If a benchmark company
sold for $1,000,000 and it had yearly revenues of $2,000,000, we would say it sold for 0.50 times revenue ($1,000,000/$2,000,000). Said another way, the selling price/revenue business valuation multiple is 0.50.
You can use this metric as an estimate or benchmark for a specific business’s worth. For example, if a business had $3,000,000 in revenue and a 0.50 selling price/revenue business valuation multiple was selected from a benchmark company, you could estimate that business’s worth to be $1,500,000 ($3,000,000 × 0.50). But we don’t typically look at one business sale in isolation. Rather, we consider a median valuation multiple for a group of businesses in an industry or part of an industry. A median is the middle number in a set, where half of the numbers are greater than the middle and half are lower than the middle. Many prefer the median to the average, as outliers can skew the average—the median is less susceptible to the effects of outliers.
Using median selling price ratios
Business appraisers use median (and sometimes average) selling price ratios for an industry to create a general ballpark value for the company of interest. Exhibit 1 below shows how you can use the data to find a general ballpark value for a business. Some take an average of the results, some select the median value, and others select the specific value that is most meaningful given the industry and/or size of the business. Each multiple creates a unique estimated value.
You may then choose to apply a weight to each estimated value to determine a final value. For some circumstances, revenues or EBITDA of a business may be more important than either earnings me sure so more weight may be applied to that value.
Industry median price multiples
The data in Exhibit 2 below is derived from the Pratt’s Stats database, which contains financial details on sold private businesses, organized by industry. We examine business sales from Pratt’s Stats to find median selling price multiples for various industries.
In addition, we compare the selling price ratios of specific business types to other businesses in the same industry. For example, we can look at benchmark data for general industries (retail trade, for example) compared to all other general industries but also benchmark data for specific business types (such as gasoline stations with convenience stores) to all other businesses in that business’s general industry (retail trade excluding gasoline stations with convenience stores). See Exhibit 3 below for an example.
Selling price multiples by sector
In Exhibit 4 below, the table compares the median selling price multiples across major industry groups as of 1Q2018. MVIC represents the selling price of actual businesses, based on thousands of private deals listed in Pratt’s Stats.
While the selling price multiples in this table serve as a rough benchmark for broad industry categories, the multiples vary when you look at a more specific industry code and take into account factors like company size and profit margins. Business appraisers and business intermediaries use Pratt’s Stats to view a custom set of deals and access a multiple that reflects their client’s business, based on actual deals for similar companies.