Determining what a company is worth is the single biggest question in any business owners mind.
The Short Answer
Find your Adjusted EBITDA, which is your normalized earnings before interest, taxes, depreciation, and amortization. Then, multiply that Adjusted EBITDA by a multiple to get to the value. The multiple will depend on your company’s size, growth trajectory, stability and capital intensity – and will almost certainly be in the 3.0x to 12.0x range.
Small, private companies less than $1 million in annual Adjusted EBITDA will likely trade for 3.0x or less, and companies with publicly traded market capitalizations in the hundreds of millions will generally trade in the double-digit Adjusted EBITDA multiples. We’ll take a closer look at what factors drive the EBITDA multiple next time.
Take a look at our free valuation submission form here in a new tab to have us do some free work for you on estimating what your business should be valued at.
The Longer Answer
A business owner’s most valuable asset is generally not the equity in their home, but the equity in their business. This is because unlike homes that usually only modestly appreciate based on underlying subjective property values, businesses are valued based on a multiple of the earnings that they generate. So an increase in profitability from gaining a new customer, decreasing costs, or increasing efficiency is subject to a multiplier effect in terms of the value you’re creating in your business.
Let’s take a step by step look at how to calculate a value based on the multiple of earnings concept.
How do I calculate my company’s earnings?
The earnings that are used for multiplier purposes to calculate your company’s value is EBITDA (an acronym for Earnings before Interest, Taxes, Depreciation, and Amortization). We use this as the earnings amount because it’s an apples-to-apples proxy for pre-tax cash flow in the business. In other words, EBITDA is meant to be representative of the income that a business generates before subjective variables like debt balance, tax payor status, or equipment purchase timing come into play. In other words, EBITDA answers the buyer’s most important question of “If I buy your company, how much money do I make per year?”
Calculating EBITDA is easier than it may sound. Here is a simple guide that will get you there:
Step 1: Look at your income statement, and find Net Income (generally it’s all the way at the bottom)
Step 2: Find the interest expense line item in your income statement, it should be in the operating expenses, and add it to the Net Income number (Note: if you run a debt-free company, you won’t have any interest expense so this number will be zero)
Step 3: Find the income tax expense line item in your income statement (ongoing taxes you pay to regulatory authorities, like a permit fee doesn’t count), and add this to Net Income as well. Note that if you’re an LLC or an S-Corp (more on this here), you probably won’t have an income tax line item expense, so this number will be zero.
Step 4: Find the depreciation and amortization expense. This can be both in cost of goods sold (“COGS”) and operating expenses, depending on how your accountant allocates this, but will typically just be in operating expenses. Find all the depreciation and amortization, and add this to Net Income as well.
After taking net income, and adding back interest, taxes, depreciation, and amortization, we now have EBITDA!
Before we move on from our EBITDA calculation, however, take one last look through your income statement – add any other line items that exist between operating expenses and net income that have not been added to net income already (i.e. gain/loss on sale of assets, non-cash stock compensation). Most small business income statements won’t have these line items, so if you don’t see them don’t worry – it’s normal not to. But it’s important to add these back if they do exist to get to a fully scrubbed EBITDA number.
Now that we have your EBITDA number, there is one step left to get to the earnings that we will apply a multiple to in order to get to the value of your company. Let’s call them ‘additional add-backs,’ although they are also known as ‘extraordinary expenses,’ ‘non-recurring expenses,’ or ‘one-time expenses.’ These are a little harder to find, but they are effectively any expenses that would not necessarily be incurred by a new owner. The most common expenses are going to be:
- Excess owner compensation. Calculate the difference in the amount you pay yourself or the ownership group annually, less the amount it would cost to replace them and still run the business on a “business as usual” basis. For example, as an owner you pay yourself $500,000 per year in salary to take some profits out of the company as a salary; but you could replace your managerial role for $150,000 per year. Add $350,000 ($500,000 less the $150,000 replacement managerial expense) to your EBITDA number. Be sure to include any accompanying payroll taxes.
- Owner/non-essential expenses. Nearly all closely held businesses have some owner expenses running through the income statement for tax purposes. Rest assured that no buyer is reporting you to the IRS for those tickets where you may have taken your daughter to the game rather than a client that one time. Add up all the expenses that you or the ownership group expense through the income statement that a new owner does not need to run the business going forward. Automobile, travel, entertainment, health insurance, benefits, etc. are usually the most common line item expenses where these owner expenses or non-essential expenses reside.
- One-time expenses. These are other one-off expenses not related to your compensation, but those expenses that would not be expected to recur every year. For example, you had a flood in your building, and had to pay a flood insurance deductible. (Hopefully) having floods in your building is not an inherent part of your business model, so that insurance deductible payment will be a one-time expense, and will be added back to EBITDA.
Add all the additional add-backs (i.e. excess owner compensations, non-recurring expenses, etc.) to EBITDA, and then we have our Adjusted EBITDA. This is your earnings number, adjusted for non-recurring expenses, to which we will apply a multiple and get your company’s value. This is a number that you can tell to any investment banker, private equity professional, or effectively anyone who works in transactional finance and they will immediately understand. It’s the universal language of deal making!
Next time, let’s find your EBITDA multiple so we calculate how much money you have tucked away in your business.