Most everyone has heard that the three most important factors in determining the value of real estate are Location, Location, and Location. It is equally true that the three most important factors in valuing an ongoing business are Cash Flow, Cash Flow, and Cash Flow.
Most sources agree that the market value of an ongoing business is usually best estimated as a multiple of its cash flow. There are several sources for arriving at the appropriate multiple, from published handbooks to proprietary databases of sold comparables to one’s own experience with the sale of comparable businesses.
A problem which frequently arises in negotiating an agreed upon sales price – either inadvertently or by design – is that buyers, sellers and intermediaries end up using the “right” multiple for the “wrong” cash flow. Essentially, they’re mixing apples and oranges.
In my experience, it’s very common that a business owner will enter the negotiation thinking that his/her business is worth ten – (or more) – times its annual cash flow. In part, I believe this is because the business owner is applying the price/earnings (P/E) ratio of a publicly traded company which is a widely published ratio, not realizing that the multiple for his privately held business will be much lower, and that his/her “earnings” are not calculated the same way as a the earnings of a publicly traded company.
Similarly, I’ve seen shrewd buyers apply the “right” multiple of historic Sellers Discretionary Earnings (SDE) to the target company’s projected EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization), perhaps realizing – and perhaps not – that they, too, are mixing apples and oranges.
There are many variations on this common error, and there are many definitions of “earnings” or “cash flow.” Even within the profession of business brokers and M&A advisors, these concepts are not universally understood, nor consistently applied.
The sale of a business is one of the largest – if not THE largest – financial transaction in a business owner’s career, so it pays to be well advised. Mistakes made in this process are very costly, and you have no chance to recover.
If you know of someone who’s thinking of selling or buying a business and who might benefit from a complimentary, confidential, consultation, have them contact me directly at 813.299.7862, or mertel@lmaallc.com
By: Mike Ertel, Transworld M&A Advisors