When engaged in pricing a business for sale we are concerned with two important numbers. EBITDA (Earnings before Interest, Tax, Depreciation, and Amortization). This figure represents the real cash flow of the business. We also will obtain a factor to multiply the EBITDA by in order to estimate the correct price range. This factor is call a “Multiple of Earnings” and we will explain this in greater depth at a later date. For now we concern ourselves with deriving the EBITA figure.
To do this we normally obtain at least a three year financial history for the subject business. For each year we will determine the net profit and then add back for Interest, Depreciation, Tax and Amortization. Once we have done this we have the EBITDA for each year.
But now that we have this information how do we balance the financial result from different years. Well let’s looks at an example below. In each case we are dealing with EBTIDA for the given year.
We could us an average to come up with a working EBITDA to apply to our “Multiple of Earnings”. However if we take an average of the last three years for Company A and Company B. We come up with the same figure $1,000,000. But note Company A has declining income. Company B. has increasing income. If we use the average method we come up with the same value but Company A is clearly worth more than Company B.
So in this instance we would normally use the most recent year earnings to apply to the multiple. Beyond this we would also look at current earnings to determine if the trend is continuing. If Company A is continuing to grow we would further take this factor into account when pricing the business. If Company B is continuing to decline we must also take this into account.
In the case of Company C – an average seems more appropriate. Averages can be useful when a Company exhibits zigzagging performance. Even so if we are going to average the EBITA for Company C we should weigh it so that the more recent financials are given greater weight – for example. We might apportion 15% of weight to 2011, 30% of weight to 2012 and 55% of weight to 2013.
This would give us the following result
2011 .15 x $1,200,000 = $180,000
2012 .30 x $900,000 = $270,000
2013 .55 x $1,100,000 = $605,000
Weighted average = $180,000 + 270,000 + $605,000 = $1,055,000
There are other factors that go into pricing a business. But the financial trend is probably the most important. In looking at a business we must determine the reason for declines and increases in earnings. It is important to know if these trends are due to one off events (such as winning or losing a big contract) or part of a long term pattern.
As a Business Broker we must take great care in properly pricing a business. A business that is priced too high will remain on the market longer and may not sell at all. A business priced too low may cheat the seller out of obtaining a fair price.
Anthony John Rigney Anthony is a Board Certified Intermediary and licensed Real Estate Broker Associate In the State of Florida. He is the Broker owner of Quorum Business Advisors. Anthony holds the designations of BCI and ABI. Visit his website at www.qbusinessadvisors.com