Tip:
Highlight text to annotate it
X
So what exactly are these standard multiples that brokers talk about when you go buy a
business? Hey everyone it’s Dave Barnett from DavidCBarnett.com. Blog site where I
talk about buying & selling businesses, local investing and personal finance. This week
I have another question from a viewer about standard multiples when buying a business.
If you want to learn how to buy a business from start to finish you should be checking
on my Business Advantage program at BusinessBuyerAdvantage.com.
I’m making this video in May 2016 and over the next two months actually have live workshops
coming up in Saint John, New Brunswick; Halifax, Nova Scotia and Boston, Massachusetts. If
you want to register for one of those live workshops which in my opinion always have
much greater value than doing the online course because of the personal interaction. Go to
DavidCBarnett.com and you’ll find a live event tab that you click on.
So what do we mean by standard multiples? Here’s the idea. I’ve made other videos
about how businesses are valued. Let me do a quick recap. Basically when we look at a
business, we have to normalize the income statement to add back things that are not
actual business expenses usually personal items related to the owner and then we take
over things that are related to the management styles such as financing costs. We want to
know what the actual cash flow is available from the business and we look at one of two
different forms of cash flow. The first one is SDE or sellers’ discretionary earnings
and that’s the total money available to an owner operator. And SDE is our base of
evaluation for a lot of very small businesses that are typically owner run. Once you get
an SDE up into the hundreds of thousands of dollars typically over half a million dollars
then people will use the EBITDA cash flow based into the revaluation. EBITDA earnings
before interest, taxes depreciation, amortization. The difference between those two is the fair
market salary of an owner-operator. So in smaller businesses people really are buying
both a business and a job so they consider the cash flow of their own income as well
as the profit of the business. In larger enterprises people just assume that the management function
has to be done by someone and that labour is worth a certain amount of money. So they
don’t include that owner-manager salary in the evaluation calculation because in many
instances the buyer the investor is not actually going to go and take that role. So think of
a small mom-and-pop shop restaurant versus a large franchise location with a hundred
employees that location could have a corporate owner in another city. So they don’t want
to look at the total cash flow including an owner-manager because they are not going to
have one.
So back to standard multiples. Here’s the idea we take that cash flow that we know is
coming from the business and we multiply it by a certain number and this is going to give
us the value of the business. Now this is a methodology for evaluating businesses and
I prefer the specific methodology called the Direct Market Data Method. Where we go into
research about that specific industry and look at other businesses that are the same
size and determine what multiple people paid for that kind of business in the past. And
it’s a really great way to see what kind of risk other buyers have basically assigned
to that type of business.
So here’s how it might work and we’ll look at restaurants because a lot of data
out there so I might have a restaurant with an SDE so it is a seller’s discretion earnings
of $100,000 and this might be a very small operation with sales. Let’s say of 375 thousand.
So if I go into my data base of past sale transactions and only certain people with
different designations and qualifications can get access to these databases but I might
do a search and look for restaurants with sales between $300,000 and $450,000 and I
might find that these little restaurants sell for maybe 1.1 to 1.5 times SDE as the which
would mean that this little restaurant might have a value of a $110,000 up to a $150,000
based on the cash flow. So that’s an example of looking at past transactions and getting
a multiplier. Doesn’t quite address the question though about standard multipliers.
Let’s take a look at it again in an other similar business same sales saying cash flow
and this is a restaurant.
Let’s assume now we’re talking about a septic pumping business. I may go into that
same data base and look at other past transactions for septic pumping businesses and the data
might tell me that those businesses sell for 3.5 times SDE same cash flow $100,000 but
in the septic pumping industry people might be willing to pay $350,000 for cash flow versus
a $110 to a 250 in the restaurant example. So why on earth is there such a huge discrepancy
between the multiples in these two industries and the answer to that question is risk. Restaurants
are very numerous, customers are price sensitive, new people can get into the restaurant business
with very little investment versus the septic pumping industry where typically you have
a couple of players and every rural area serving clients. People call them every couple of
years so they’re not quite sure what it should cost and if the prices change over
3-year period people are less likely to notice. So there’s more pricing flexibility in that
industry and in order to get into that business you might have to buy or lease a half-million
dollar truck as well as get environmental permits you know all that kind of stuff so
it’s harder to start a septic pumping business, it’s easier to raise your prices it’s
less risky, there’s less competition and therefore people are willing to pay more for
the septic pumping cash flow then they will further restaurant cash flow.
Now here’s the funny thing that happens. Let’s look at another restaurant. So let’s
say a restaurant that does two million dollars in sales and has a SDE of $200,000. You might
say well David a restaurant shouldn’t be worth between 1.1-1.5 times and the answer
is no its not. When we go in and look at past transactions what we find is that as businesses
get bigger the multiples change. So in this case again it’s a restaurant but it’s
a much larger going concern. We could find that restaurants in this league over one point
and SDE maybe up to 2.6 times SDE. So we end up with a business that’s worth between
$360,000 maybe up as high as 15, 20 it’s still a restaurant but buyers consider a bigger
economic unit to be less risky than a smaller economic unit. Now sometimes when you get
out there in the wide world business brokers and accountants and other people who are trying
to put values on businesses they’ll try to convince you that all businesses are worth
a certain multiplier of cash flow. And what I’ve seen in my experience is people out
there saying that the business is worth between 3 and 5 times earnings.
The problem is this: they don’t always normalize the cash flow using the same set of rules
and sometimes people are under the impression that you multiply the earnings in order to
get value for the goodwill. Which is actually not the case using a method like this is supposed
to give you an enterprise value. Enterprise value is inclusive of all the equipment machinery
and operating capital required to make the business function. So I’ve run into people
who have gotten what they thought was expert advice where they’ve come up with the cash
flow figure that wasn’t properly normalized, they multiplied it by three thinking that
was a standard multiple, for valuing the goodwill of the business and then they’ve added the
operating capital and value of the fixed assets and come up with a number that made absolutely
no sense. we’re talking like a business with 80 or 90 thousands dollars and earnings
being valued at $1,000,000 doesn’t happen in the world of small and medium-sized enterprise.
So I always get very suspicious when people start talking about standard multiples when
valuing your business because what it means to me is that they’re trying to use some
jargon language to give themselves credibility or authority and they may not actually have
access to the research or they may not even know that they can do it this way. So when
people are telling me that have business is worth what it is because of standard multiples
I would usually tend to tell people that that’s a cue to go and get advice from someone else
that can help you. I help people like this everyday in fact.
Thanks a lot and we’ll talk with you later. If you found this information useful please
like or share the video. Wherever you’re watching it; LinkedIn, Facebook, YouTube,
it’s the only way that these platforms have knowing that the content is actually good.
Thanks and we’ll see you next time.
You made it into the video, that’s great why not come over to my blog site InvestLocalBook.com
where you can see all my latest posts and videos. You can also take the time to watch
my welcome video see what I’m all about and if you wish sign up for my email list.
I only send 1 email each week, you get to choose which topics you’re interested in
so that you only get information that you want to learn about as easy to unsubscribe
anytime. Click my free resources link and have access to all of my free eBooks, audiobooks
and other PDF downloads.