5 February 2024: Valuing a Business – Earnings
Over the past two weeks, we’ve posted twice about some of the methods we use when valuing businesses. In the first post on this topic we discussed from a high level vantage point four methods we use regularly. Last week’s post was a deeper dive into the Comparables Method; specifically, determining what comparable businesses have sold for recently.
Of course, defining what “comparable” means is important before embarking on any valuation and we did that, more or less vaguely, in that last post. But the comments and emails received made clear to us that a deeper discussion is in order. So let’s dive in.
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At its base, most of us have some idea of what “comparable” means in the context of valuing a business. In both of the last two posts, the following text was used:
“Whatever business is the subject of the valuation discussion, it is highly unlikely that it is the only business of its kind in existence.
There have been dozens of small manufacturers and plumbing companies sold in the past five years. The same can be said for eCommerce, logistics, distribution, real estate, convenience stores, auto repair, IT businesses, tire, shoe and apparel retailers, and any other business you can think of.”
Pretty easy, huh?
Well, not really because we have to filter for size, required licenses, certifications, geography and a dozen or so other considerations. Arguably, the most important of these considerations is the definition of “size’.
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We’ve broken our Flagship into six separate modules (or module groups) to give you all the flexibility you need to learn only what you want to learn – and we’ve moved them all over to the new Brokers Academy in The Brokers Roundtable℠ . The Flagship is still available but the modules are now available individually.
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Valuing a Business: Size Matters
When we begin the valuation discussion with business owners, we’ve found that they define size in different ways. Some believe it refers to the size of their facility(ies). Others, the number of employees they have (the size of their work force). Still others, equate “size” with the number of customers or clients they serve or even the size of one or more of those clients without regard to the amount of revenue each client or customer contributes to the business’ operations. (We often see this when the business we’re valuing sells to a company like Walmart. Walmart may account for only 8% of the business’ sale but, hey! it’s Walmart!)
Some business owners think the number of locations they have or the scope of the geographic footprint of their business is a significant factor. For example, we have valued several tax preparation businesses with multiple locations, ranging from a five-unit chain in a single city to one with 120 units spread out over three states.
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Our course, “Learn How to Value and SUCCESSFULLY Sell Businesses“, teaches you how to accurately value and successfully sell businesses.
But none of these measurements move the needle much. When valuing a business, especially when using the Comparables Method, when we talk about size, we’re talking about financial size: revenue and earnings. How much that business brings in and how much of THAT number STAYS in; that is, doesn’t get spent for the business’ operations. Of the two, revenue is a distance second to earnings in importance.
Revenue and Earnings
As we’ve often mentioned, financial buyers – who make up the majority of buyers of businesses that have less than $1 million in earnings – are interested in the answer to this question: “How much will this business put in my pocket?” (Over the past 18 months or so, we’ve 
seen an uptick in inquiries from small-ish private equity groups, search firms and other so-called “strategic buyers” that have lowered their minimum financial performance standard to businesses with as little as $500,000 in earnings, but still the vast majority of buyers of these smaller businesses are financial.) This question alone suggests that, when valuing a business, earnings – how much of the revenue stays with the business owner at the end of any given year – is the standard to which we must give the greatest weight.
Therefore, “comparable”, when it relates to size, must first mean comparable to other sold businesses in earnings and, second, comparable to other sold businesses in revenue.
But now that we’ve determined that earnings are the key number, we have to define “earnings”. (All these definitions! YIKES! We almost need our own dictionary!) And herein lies the hard part; the work, the training, the calculations and the experience.
Earnings are rarely the bottom line numbers shown on the profit and loss statement. They’re almost never what’s shown as “taxable income” on the tax returns. Earnings are calculated through a process referred to as “recasting” – recasting the business’ earnings. We’re looking for what we refer to a “discretionary earnings“.
Recasting involves a thorough analysis of the business’ profit and loss statement, its balance sheet and its tax return. Our objective is to ferret out entries that aren’t absolutely critical to the business’ operations or that are not incurred annually.
An example of the first might be membership in the business’ industry association. An example of the second might be the costs of replacing the business’ IT network.
The Bottom Line
Most businesses don’t sell when they first come to market, primarily because the owner has an exaggerated opinion of its value. Such businesses are listed by real estate agents or untrained business brokers who have no idea how to value a business. This is almost always the case when a business owner decides to try to sell their business themself.
But valuing a business a business before bringing it to market is arguable the most important part of the process. It informs the seller and, if the seller wisely chooses an experienced broker, the broker how to price the business, how to justify to potential buyers that price and how to negotiate the terms of the deal.
I’d like to hear from you. What topics would you like me to cover? How can we tailor these posts to be more useful to you and your business. Let me know in the comments box, below, or email me at
jo*@Wo*******************.com
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If you have any questions or comments on this topic – or any topic related to business – I’d like to hear from you. Put them in the comments box below. Start the conversation and I’ll get back to you with answers or my own comments. If I get enough on one topic, I’ll address them in a future post or podcast.
I’ll be back with you again next Monday. In the meantime, I hope you have a safe and profitable week.
Joe
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The author is the founder, in 2001, of Worldwide Business Brokers and holds a certification from the International Business Brokers Association (IBBA) as a Certified Business Intermediary (CBI) of which there are fewer than 600 in the world. He can be reached at
jo*@Wo*******************.com