Three reasons why business owners overestimate the value of their business
If you are planning to sell your business to a third party, an accurate valuation is essential to properly price the business and provide a benchmark for evaluating competing bids.
In simplest terms, a business is often valued by applying a multiple to a maintainable profit stream. Business owners may hear about a competitor selling their business for a certain EBITDA multiple. EBITDA represents “Earnings Before Interest, Taxes, Depreciation and Amortization”. For example, if your competitor’s business sold for 6 x EBITDA, you might believe that your business should also be valued at 6 x EBITDA… but this may not be the case.
This blog will outline 3 factors that can result in a pronounced difference between a business owner’s perception of the value of his/her business and its fair market value.
It is important to ensure that you are comparing apples to apples when looking at the multiples used in the pricing of a competitor’s company. For example:
- Was the multiple used in the sale of a competitor’s business applied to pre-tax earnings (e.g. EBITDA) or after-tax earnings? The multiple used should be consistent with the income stream (i.e., pre-tax multiples should be applied to pre-tax earnings and after-tax multiples should be applied to after-tax earnings).
- Was the purchaser of the competitor’s business a strategic purchaser that may have been one of a number of special purchasers able to derive synergies by acquiring the business (e.g. eliminating a competitor, access to a geographic territory/market, larger volume discounts in subsequent supply agreements, etc.)? If so, and no special purchasers have been identified for the purchase of your business, the multiple applicable to your business may be lower.
- Is your business truly comparable to that of your competitor? Each business has its own unique risk factors. The greater the risks, the lower the multiple. For example, consider the following risk profile differences vis-à-vis your competitor:
- Is the business highly dependent on the owner, such that customer and supplier relationships would be difficult to transfer to a purchaser? When a business is too dependent on the owner, there is a risk of losing customers, key employees, and suppliers.
- Do customer and supplier contracts exist?
- How diverse is the customer base; is the business reliant on a few large customers?
- Are there significant size, geographic, and other differences?
The amount of annual capital expenditure that is required each year to sustain operations will need to be considered in the business valuation. A deduction for such expenditures would be partially reduced for the tax benefit of the expense. If the full extent of the capital expenditures is not considered, it could result in an overestimate of value.
When a business is valued by applying a multiple of maintainable EBITDA, the amount of interest-bearing debt needs to be deducted from the calculated value. Your competitor’s balance sheet may not reflect any debt, and therefore the 6 x EBITDA value would represent the value of the equity. If your business is financed by interest-bearing debt, the amount of this debt must be deducted in arriving at the value of your equity in the business.
If you’re looking to sell your business or transfer it to the next generation or management, our team of reputable Chartered Business Valuators can provide you with an objective and reliable valuation, and advise you on steps you can take to maximize your profit when selling your business.
To schedule a complimentary consultation with one of our business valuators, contact us today.