A valuation multiple is an expression of the market value of a company when related to a particular value. You can have valuation multiples based on certain assets, cash flow, reported earnings or other selected reported or calculated numbers.
For privately held businesses, often the multiple used in business sales transactions is a multiple of AEBITDA. AEBITDA is Adjusted Earnings Before Interest, Taxes, Depreciation, and Amortization. This number is a good estimate of the actual cash flow that the buyer would expect to receive after purchasing a specific company.
There are many other methods to calculate the value of a business, including Discounted Cash Flow, but this blog post focuses on AEBITDA.
Often small businesses focus on paying the least amount of income taxes, so their published financial results may understate the cash flow that is being generated by the company. Lower financial results can be generated by excessive write-offs of normally capitalized items, payment of executive high salaries, high amounts of payment into retirement accounts, and expensing personal expenses of the company owners.
An educated and experienced buyer often understands this and allows for adjustments to the actual numbers published by the company’s accountant. Also if the company owners are not going to stay on with the company, then their total compensation is added back to the company’s estimated cash flow and the expected compensation that would be paid to someone brought in to run the company would be deducted from the estimated cash flow.
These adjustments are typically discussed and negotiated during the process leading to a sales transaction.
Once this AEBITDA is calculated, then a multiple is used to calculate the value of a business. For example a company generating $4 million of AEBITDA in an industry where multiples average 4 times AEBITDA, would sell for around $16 million dollars.
There are many factors that influence what this multiple would be in each given business sales transaction. To learn more about increasing the value of a business click this link.