I performed a valuation for one of our agents and the business owner really wants to understand the calculation behind the value. I told the agent that it was a trade secret and that we were not privy to that information. The business owner was less than satisfied with that answer. Is there any additional detail we can provide that might satisfy him?
There are myriad nuances which impact the final estimates of value, but the foundational value is most often a function of "discretionary earnings" (for smaller firms) and "adjusted EBITDA" (middle market firms). In short, the firm's normalized earnings are applied against the pertinent "multiple" or "cap rate" to produce the so-called asset sale value (which, as you defined, includes only a specific set of assets; inventory, FF&E and all intangible assets).
In the "big picture", the "equity value" is generated by way of adjusting the asset sale value up or down depending on the relationship between the firm's "liquid financial assets" (cash, A/R, other current assets) and its liabilities (ST and LT), i.e. the liquid financial assets raise the asset sale value and the liabilities reduce the asset sale value - to reach the equity equivalent value. The equity value therefore equals the asset sale value PLUS liquid financial assets MINUS liabilities.
From an algorithm perspective, the core value (asset sale value) is generated chiefly through the application of multiples of discretionary earnings or adjusted EBITDA (which are adjusted up or down based on many different factors). We also use revenue multiples (weighted with the earnings-based estimate) and apply implicit discount rates when valuing startup, low profit, high growth and high tech firms.
As per the attachment:
The BizEquity proprietary algorithm dynamically produces discount rates (D), capitalization rates (C) and multiples (M) which are:
• Market-Based
• Industry-Specific
• Size-Adjusted
• Company-Specific Risk-Reflective
• Real Time-Updated Via Myriad Sources
Our algorithm utilizes market transaction multiples drawn from myriad resources which are industry-specific (over 500 five digit NAICS codes), size-adjusted (as earnings rise, so too does the pertinent multiple) and company-specific risk reflective (customer concentration, impact of owner departure, profitability, growth, recurring revenues, amount of tangible asset base, etc.). Specifically, multiples of revenue, SDE and adjusted EBITDA are sourced and adjusted depending on factors such as industry, size of revenues or EBITDA, relative profitability, degree of tangible assets, etc. Implicit discount rates are also used for startup, high tech and high growth firms based on proprietary data obtained from one of the leading venture capital firms in Silicon Valley.
Overall, there are literally dozens of factors which drive the final estimate of business value. Our system essentially mimics that performed by a professional appraiser when seeking to value owner-operated businesses.
With respect to the company named ABC, the pertinent results are noted below:
Asset Sale Value $1,396,000
Equity Value $4,579,000
Remember that the asset sale value is calculated first in an algorithmic sense, with this estimate of $1,396K equal to right around 4 times the firm's most recent annual SDE (seller's discretionary earnings). Once the asset sale value estimate is derived, the equity (and enterprise) value estimates can be calculated.
The LARGE differential between the asset sale value and the equity value goes to the excess of liquid financial assets ($4,270K before any adjustments) for the firm relative to its liabilities ($915K) as of the most current balance sheet date. An approximate differential of around $3.2m exists due to high cash and A/R balances versus existing debts. Some of the pertinent SDE data is presented next:
2015 SDE $433,000 $43,300 (10%)
2016 SDE $938,000 $187,600 (20%)
2017 SDE $353,000 $247,100 (70%)
Bizequity Weighted Avg. $478,000
3 year avg. $578,000
2 year avg. $646,000
1 year avg. $353,000
During 2016 and 2017, the firm generated discretionary earnings equal to approximately $646K on average for a multiple of around 2.2 times. Based on the most current year results of $353K, the asset sale multiple is approximately 3.95 times. The Bizequity system weights the current year the heaviest at around 70% with 20% and 10% allocated to the prior periods, such that the weighted average SDE of $478K represents a final multiple of around 2.92 times (close to 3 times).
For a company with around $390K in SDE during 2 of the past 3 years, the final implicit multiple of around 3 times is considered quite reasonable for this company size and type.
The fact is that valuation is both an art and a science such that five professional appraisers hired to value this company would produce five different estimates with a probable differential around the mean of plus or minus 15%.
In order to provide additional insight into the Bizequity algorithm, please review the following attachments at your leisure.