As a business broker and appraiser,
I’m often asked what a business is worth. The appraisal of privately held businesses is not an exact science but there are guidelines and rules-of-thumb that can be used for a close approximation of value.
Certain situations require a formal business appraisal including the larger merger-acquisition transactions, SBA loan applications, management performance tracking, estate planning, divorce — or the most dreaded of all — IRS issues. After all, a professional, fully documented appraisal certainly takes the guesswork out of the situation.
However, what we’re talking about here is not a formal appraisal but rather the informal methods of quickly approximating the value of a business entity. All of the guidelines we’ll quote are averages derived from hundreds of completed transactions reported to national and regional databases.
There are two methods of quickly approximating value: (1) applying a multiple to the cash flow of the business and (2) applying a percentage to the annual gross revenue of the business.
The most accurate of the two rules of thumb seeks to approximate the value of a business by applying a multiple to the company’s discretionary cash flow. What is discretionary cash flow? It is NOT the profit or loss that you show Uncle Sam on your tax return. To put it delicately, almost all business owners run some expenses through the business that are not — a’hem – absolutely necessary to the operation of the business.
Discretionary cash flow is the total cash that the business generates in a year that is available to the owner after deductions for only the necessary operating expenses. Another way to define discretionary cash flow is that it is the “total owner’s benefit” derived from owning the business, regardless of how the owner takes the money out of the business. It is the amount of cash left over after necessary expenses that is available for (1) owner’s remuneration, (2) return on investment and (3) debt service, if any.
Almost all privately held businesses will appraise for somewhere between one to five times discretionary cash flow (DCF). Exactly where in this range that a specific business falls depends on the type of business.
From the database of completed transactions, we know that an air-conditioning/heating contractor, for example, is valued at approximately 2 times DCF. A hardware store is worth about 3 times DCF. Home health care is 4 times; janitorial services at 1.5 times; jewelry stores are 5 times. Manufacturing operations will sell for between 3 to 5 times DCF depending on several factors. Wholesale distributors in general are valued at around 2 times DCF.
A less accurate method of estimating the value of a business is to apply a percentage to the company’s annual gross revenue. For example, a full service restaurant with a liquor license will be worth about 30% annual gross revenue if it’s earning the average bottom line profit for its peer group.
As other examples, dry cleaners will be worth approximately 75% of annual gross revenue and weekly newspapers often sell for 100% of annual sales.
None of these appraisal guidelines include the value of any real estate or inventory on hand. If the business owns real estate, the value of the realty should be added to the guideline result. And inventory, at cost, should also be added to obtain the total estimated value of the business.
However, you as the owner, seller or buyer of the business are the final arbiter of what the business is worth to you. Remember, these guidelines are only averages. And the guidelines certainly don’t take into account any special considerations or any future plans that an owner might have for the business. What a particular business might be worth to you may be more or less than it’s worth to the next person who looks at it.
One final observation: Interestingly, there is little geographic deviation in the value of businesses. A gift shop in Alabama with similar financial performance is worth about the same as one in California.
If you have questions about business valuation, please contact me at (251) 626-4949 or WilliamBruce@bellsouth.net. In addition to estimates of value using rule-of-thumb guidelines, we also do written, fully documented business appraisals for banks, business buyers and sellers, minority / majority partners and others.
In our practice, we also provide nationwide consulting services to individuals who are considering buying or selling a privately held business.
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Hey Will,
You’re a rare find! I concur with your astute commentary. As a former Business Broker (who preferred to be called an Intermediary Consultant–since we worked both sides of the transaction, but never concurrently), I totally respect YOU but still don’t have a warm and fuzzy feeling about the low-end brokerage industry in general.
My biggest issue was that “they” were always more interested in “getting listings” and not representing clients. Back in the day, we actually refused more “listing” than we took–simply because without full disclosure before-the-fact, there was nothing to talk about.
We knew what we needed and if a prospective client couldn’t/wouldn’t comply, it made no sense to get involved. The notable exception was the owner who had established an asking price. We challenged him to demonstrate that his business had such worth. (In 20+ years, only one rose to our criteria–by producing a formal, third-party valuation.)
For my money, any deal that did not have such a “tool” at hand, before attempting to go to the street, was a waste of time–surely precluding our involvement. In other words, every client that we represented (not “listed”) had to have (our firm mandate) a valuation–period. This when we started to charge a retainer–yes, even on the low-end. $5,000 was magic (put-up or shut-up) number for deals under $1 million, and $10-15,000 on larger transactions.
Okay, you guessed it: huge-resistance initially…but logic prevailed…or we said goodbye. Granted, the main st (low-end) was not used to wall st tactics, but we knew our worth measured by our percentage of success. We didn’t work for common commissions … ours were success fees, and very well earned at that! Sorry, enough reminiscing…
Good luck, my friend, stay well, and keep on helping “clients” on the low-end, and they should be constantly reminding every time they call upon you: “in the real world, you always deserve what you pay for” (or didn’t!).
Best regards,
Bob
Thanks, Bob, for your kind comments. I appreciate your perspective. What are you doing now after your intermediary days?
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Very interesting topic , thanks for putting up.
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Greetings Bill:
Nicely presented article!
You’ve hit it squarely as to a value overview.
I’ve been an Advisor, Business Broker and Appraiser for more than thirty years.
It’s refreshing to see competence and experience presented so well.
Thank you!
Paul
Paul, thanks so much for your kind words. Where are you located?
Terrific post. It’s a real, real shame more entrepreneurs don’t understand this.
An interesting note for entrepreneurs: all of the methods discussed above involve multiplying your earnings by some other number(s). Zero times any other number is zero. Therefore, if you have no earnings, your business’s value is zero (plus any valuable assets you may hold, like real estate).
Good ideas, sweat and tears, ambition and potential are literally worthless from a financial perspective. I’ll say it again: if your revenue is ZERO, your firm value is ZERO. If you’re going to appear intelligent in conversation with investors, you MUST understand how firm value is really created.
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What is the multiplier for gross revenue on an automotive shop?
Steve, thanks for dropping by the blog. Auto repair shops are valued at 35% to 45% of annual revenue plus inventory at cost. Or another more accurate guidleine is 1 to 2.5 times discretionary earnings (adjusted cash flow) plus inventory for businesses with discretionary earning below $100K, and 3 times discretionary earnings for businesses over $100K in earnings.
Hope this helps. Let me know if you need assistance in valuing a business.
Best wishes,
~William
How about an online business? I have an opportunity to buy an online pet retail business that is basically a one-person operation. Average profits for the last five years are 300k, with expenses of 50k. Assets estimated under 10k. It’s such a simple set-up that I’m having trouble finding a good reliable valuation for it, and I’m not sure what to offer her.
The rule-of-thumb valuation range for e-commerce sites is 2.5 to 4 times seller’s discretionary earnings (cash flow). Where in this range a particular business falls depends on the market trends, the particular company’s trends (growing or declining) and the willingness of the seller to finance a portion of the investment, among other factors.
Is there a tried and true formula for determining discretionary earnings?
She wants to owner finance.
Discretionary earnings, also know as owner’s cash flow is computed as follows:
To the profit or loss shown on the business tax return, add
1. Owner’s W-2 salary (if any)
2. Any non-cash deductions (eg: depreciation, amortization)
3. Any owner’s perks listed in expenses that are not necessary operating expenses of the business (eg: vacations charged to the business, cars, etc.)
4. Any one time repair or other expense that will not likely recur
5. Any interest expense
The result is discretionary earnings. The definition of discretionary earnings is that amount of cash left over after only the necessary operating expenses of the business have been paid that is available for (1) owner’s remuneration, (2) return on investment and (3) debt service, if any.
Hope this helps.
~William
William,
Could you tell me what the multiplier for cash flow is for a mail, pack and shipping franchise? What about a percentage of gross sales also.
Thanks
Steve, the guidelines for a pack and ship store are:
(1) 40 to 45 percent of annual sales
(2) 2 to 3 times discretioanry earnings (cash flow)
Both of these guidelines include inventory. The multiple of discretionary earnings guideline carries more weight than the percentage of annual sales guideline.
Best wishes,
~Will
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