For example, the direct capitalization techniques, such as the well-known Multiple of Discretionary Earnings and Capitalized Earnings methods, use a single number as its earnings input. You also need to make a matching choice of capitalization rate.
This gives you a measure of business risk. Now plug in these inputs to get very accurate business valuation results.
Earnings and cap rate – a matching pair
There is a big advantage to the Multiple of Discretionary Earnings method. Importantly, it automatically matches your business earnings and the capitalization rate. This is a key requirement for accurate business valuation.
Multiple of Discretionary Earnings uses seller’s discretionary cash flow (SDCF). It is also known as seller’s discretionary earnings (SDE). In addition, you need to assess business risk across a number of essential financial and operational business performance factors.
Picking your earnings number
So how do you choose the business earnings number? There are several choices to consider:
- Simple average of SDCF taken over several years.
- Weighted average SDCF value.
- Squared weighted average SDCF value.
Your should choose the earnings estimate that best represents the business income prospects going forward.
For example, if the earnings don’t change much year over year, a simple average of SDCF over the last 3 – 5 years is a good choice.
On the other hand, the weighted average and, to a greater extent, squared weighted average schemes put stronger emphasis on the most recent history. These choices are best if your business earnings changed significantly in recent years.
Handling unusual years
Feel free to come up with your own weighting scheme if you want to handle unusual years. That is, the years showing business earnings that are either much higher or lower than normal.
Let’s say that you need to value a business with the following seller’s discretionary cash flow history over the last 3 years:
- Earliest year (1): $100,000
- Year 2: $135,000
- Most recent year (3): $159,000
Based on your analysis, the business shows average performance across all 14 financial and operational performance areas considered by the Multiple of Discretionary Earnings business valuation method. Given this, you decide that, on a scale of 0 – 44.0, the business gets a rank of 2.5 in each area.
Business net working capital is $50,000; and it has no long-term debt. Business leases its premises and, in your judgement, carries no excess or non-operating assets.
Scenario 1: Business valuation result using the simple average to calculate the earnings basis
In this case, your business earnings are just the sum of the 3 annual values divided by 3:
($100,000 + $135,000 + $159,000) / 3 = $131,333.
Using this value along with the $50,000 for the business net working capital and setting all performance weights to 2.5 produces the following business valuation results:
Business Value = $378,333.
Scenario 2: Business valuation result using the squared weighted average to calculate the earnings basis
This time, you decide that business earnings in the more recent past are better indicators of what the business will likely earn in the future. You select the weights of 1, 2 and 3, square them, and calculate your earnings input as follows:
($100,000 x 1 + $135,000 x 4 + $159,000 x 9) / 14 = $147,929.
Your business value calculation now produces a different result:
Business Value = $419,823.
This is around 11% higher than the result you got with the simple average earnings in Scenario 1 above. No surprises here: your earnings input is higher.
What this means is that you expect the business earnings to fall in line with the higher values seen in the more recent years. This business growth upside is correctly captured by your Multiple of Discretionary Earnings business valuation.