Business Value = Multiple X Profits? Part 1

OK. You have all heard it. #business value is a Multiple of Profits. Simple, isn’t it? Actually, it is not! We need to find the Multiple, define Profits and make sure that we understand what the number we have arrived at represents.

Surely enough “Profits” are a universal concept. Tax authorities around the world tax businesses on Profits. But are we all equally sure about the number we are going to plug-in as “Profits” in the formula? 

To start with, are we going to use “accounting” Profits or “true” Profits? Surely enough, all over the world, the two terms do not yield the same number!

Finance theory tells us that we should concentrate on #ebitda, Earnings before Interest, Taxation, Depreciation and Amortization. However, taxes are a very important determinant – especially if your business is located in Greece – of the business owners’ take-home pay. How come they are excluded from the metric that defines company value?

Well, the answer is that we need a metric that both a) reflects the true income generating ability of the business and equally importantly b) ensures comparability across companies and even across countries.

The Profits that we are going to plug-in in our formula should be the “true” Profits of the business. In order to calculate these “true” Profits we must a) ignore any discretionary personal (or family) expenses that somehow found their way on the company’s accounts b) charge the business a fair-market rent if it is using a building owned by the business owner and c) charge the business a fair-market wage for all family members working in the business and ignore wages paid to non-working family members.

As if all that was not complicated enough, we must now make a distinction between small businesses – where the norm is that the business is managed by the owner – and medium businesses that are managed by paid professionals. For Small Businesses we use the metric called SDE (Sellers Discretionary Earnings). In this case, we ignore any salary or any form of benefit (e.g. social security contribution) the owner receives from the business. But these are true and legitimate expenses of the business. How on earth can we ignore them?

The answer is once again, comparability reasons. We want to treat a business that is showing profits of € 10.000 without paying any salary to its owner as an exact equal to a business that is showing € 0 Profits but is paying € 10.000 as a salary to its owner.

If, however, we are trying to calculate the value of a medium business, not only we should not ignore owner’s salary but we must adjust it to a fair market wage. If the owner is an acting CEO without getting paid, then we should charge the business with what it would take to hire a professional manager. The use of #ebitda presupposes fair market wages of a complete professional management team.

OK. Now that we have the correct definition of SDE or #ebitda can we use our formula? Yes, if we know which year’s earnings we are going to plug-in. Oh, this is really easy: last 3 or 5 years average. Correct?

Actually, NO. We should use the Profits that reflect the “typical year” of the business going forward. Past Profits are only useful to the extent they help us determine future Profits. In order to use the formula we must plug-in the realistically expected and maintainable future income of the business.

How are we going to calculate it? With a detailed analysis of the business’s past and by making realistic assumptions about the future. Wait a minute, this is subjective. Yes, it is, indeed. Welcome to the world of calculating company value. It is both an Art – in determining future income – and a Science in calculating the value once the future income has been determined.

In the Formula “#business value = Multiple X Profits”, Profits must equal the realistically expected and maintainable future income of the business. We will address the multiple and what we are actually trying to calculate in future posts.

Yiannis Empeoglou, CBI®, is an M&A Consultant and Intermediary based in Athens, Greece. He is the author of the book "How much is a business worth" that was originally published in Greek and is now also available in English. You can find more information on the author and the book on https://howmuchisabusinessworth.wordpress.com/. The book is available through Amazon and through the Createspace e-store. IBBA members are entitled to a 25% discount through the Createspace e-store.