Historical Earnings Valuation

April 13, 2006

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Most small companies are valued using one or more of the following methods, which take into account the company's historical earning power. In contrast to the asset-based methods, historical earnings methods allow an appropriate value for the goodwill of your business over and above the market value of the assets, if that's justified by your earnings. Although savvy buyers will be more concerned about the future of your business than its past, predicting the future is difficult. The assumption here is that your past history provides a conservative indication of the amount, predictability, and growth trend of your earnings in the future.

Accordingly, the starting point for all these methods is the recast historical financials that show how the business would have looked without the owner's excess salary and perks (that is, compensation over and above what a non-owner manager would be paid), nonoperating or nonrecurring income/expenses, etc. A judgment call must be made as to whether you should look only at the last year's statements, or at some combination of statement results from the last three to five years (the most common combinations are a simple average, a weighted average that values the most recent years more heavily, or a trend line that factors in the percentage and direction of growth each year).

Debt-paying ability. This is probably the method most commonly used by small business purchasers, because few buyers are able to purchase a business without taking out a loan. Consequently, they want to be sure that the business will generate enough cash to pay the loan off within a short time, usually four to five years. The price must be set at a point that makes this possible. Simply put, to determine the company's debt-paying ability, you'd need to start with the historical free cash flow; this is usually defined as the company's net after-tax earnings (with a reasonable owner's salary figured in) minus capital improvements and working capital increases, but with depreciation added back in. Interest on any existing loans is usually ignored, so that you start with a picture of the company as if it were debt-free. Multiply the annual free cash flow by the number of years the acquisition loan will run. From this figure, subtract the down payment. The remainder is the amount available to make interest and principal payments on the loan, and to provide the new owner with some return on investment.

For example, if your free cash flow was $80,000 a year and it's reasonable to expect the loan to be repaid in four years,

4 x $80,000 = $320,000.

If the down payment were $80,000, then no more than $240,000 (or $60,000 per year) would be available to make interest and principal payments on the loan, and to provide the owner with some return on the investment ($320,000 - $80,000 = $240,000. $240,000/4 = $60,000).

If the owner expected a 20 percent return on this $80,000 down payment, that would translate to $16,000 per year, further reducing the amount available to make debt payments to $44,000 ($60,000 - $16,000 = $44,000).

An annual payment of $44,000 could support a four-year loan of approximately $130,685 at 10 percent interest, or $145,000 at 8 percent interest. Add the loan amounts to the downpayment, and you arrive at a total purchase price of $210,685 at 10 percent, or $225,000 at 8 percent. If the lender is willing to finance the deal for a longer term or a lower rate, a higher price would be possible.

Capitalization of earnings or cash flow. This is another commonly used method. Basically, it involves first determining a figure that represents the historical annual earnings of the company. Generally this is EBIT (earnings before interest and taxes) but sometimes EBITD (earnings before interest, taxes, and depreciation) is used. Some buyers prefer to use free cash flow, as discussed above. At any rate, the chosen figure is divided by a "capitalization rate" that represents the return the buyer requires on the investment in light of the market rate for other investments of comparable risk. For example, if the EBIT was $100,000 and the buyer required a return of 25 percent, the capitalization of earnings method would yield a price of $100,000/.25 or $400,000.

Gross income multipliers/capitalization of gross income. Where expenses in a particular industry are highly predictable, or where the buyer intends to cut expenses drastically after the sale (for example, where the buyer is already in a similar business and can centralize administrative functions), it may be reasonable to value the business based on some multiple of gross revenues. For example, some service businesses can be valued at four times their gross monthly income. A variation on this would be to divide the gross income figure by a capitalization rate, as with the capitalization of earnings method discussed above. The problem with either of these methods is that they ignore the fact that two businesses in the same industry with similar revenues can have greatly different profitability margins, depending on their expenses.

Dividend-paying ability. This method is listed by the IRS as a possible valuation method for small businesses. However, in practice it's rarely used for small, closely held companies. The reason is that the ability of a small business to pay dividends is directly dependent on its earnings, so it's usually more appropriate to look at the earnings themselves. Furthermore, many small businesses try to minimize their payment of dividends for tax reasons, so looking at the company's past record of dividend payment is not a good indication of the company's value.

One situation where it may be useful is if you're trying to sell a minority interest in the company, and you want to show that there has been a pattern of receiving dividends in the past. Minority interests in closely held businesses are generally very difficult to sell, because the owner usually can't force the payment of dividends or any other corporate decision; showing a pattern of dividend payments may be a way to make the interest marginally more marketable.