The value of a business is a function of two variables:
1. The expected future cash flow of the business, and
2. The present value of the expected future cash flow.
Present value is determined by a discount rate, i.e., the rate at which the present value will equal the expected future cash flow. It is the rate a buyer of the business would expect to earn on its investment.
Because future cash flow is difficult to predict, valuation experts often rely on the past as a predictor of future cash flow. They may use a substitute for cash flow called EBITDA (earnings before interest, taxes, depreciation, and amortization) and estimate future EBIDTA using an average of the past years most likely to be repeated.
The present value of future cash flow is somewhat difficult to calculate. A number called a multiple is easier to use. The multiple times the expected cash flow can serve as the present value. A business with an expected future cash flow of $500,000 is worth $2,500,000 if the present value discount rate is 20 percent (0.20). The discount rate divided into 1 is the multiple, in this case 5.
Average present value discount rates/multiples for businesses in your industry can be determined by talking with professionals who have experience in the industry: Merger and acquisition specialists, accountants, trade association executives, etc. can help. But your business is unique. The discount rates/multiples are affected by risk, or perceived risk. The higher the risk in your business, the higher the discount rate and the lower the multiple.
Risk can be affected by many factors, such as:
1) Management strength — if the departing owners are the only managers in the business, risk is higher
2) If the business has a few customers accounting for a large portion of the revenue, risk is higher
3) If there is high turnover of personnel, risk is higher
4) If there is low or no geographic diversity, risk is higher
5) If there are weak systems controlling business operations, risk is higher So, business owners should use the typical discount rate or multiple for businesses in their industry, as discussed above, and adjust up or down dependent on the risks described in 1 through 5 above.
Finally, EBITDA should be normalized. The future earnings of the business may not be the same for the buyer of a business as for the seller. They’re affected by certain variables. Interest has already been added back because buyers usually buy the business debt free, and may or may not use their own debt. Taxes have been added because the tax rate may be affected by the organization structure and other factors. Depreciation has been added because it does not use cash. But capital improvements do use cash. Expected capital additions should be deducted from EBITDA. And, of course, any other expenses or revenues that will not affect the buyer should be accordingly deducted from or added to EBITDA.
The resulting valuation may not be the same as that determined by a professional in the merger and acquisition or valuation business, but it is a good starting point for planning or for satisfying your curiosity about the value of your company.