5 Ways Businesses are Valued Incorrectly

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Posted by Jennifer Smith Broeckling on

Most business owners have no idea what their business is actually worth.

The reasons that business owners typically seek out a valuation are: 1) They are working on a financial plan with their financial planner; 2) they are going though a major life event (divorce, illness, etc.); 3) they are contemplating selling their business (or buying another business).  Value is not something you want to guess at. You also should not base your value on an article you read or what your uncle’s company sold for. Valuations are highly individualized and because we see so many businesses valued incorrectly, we want to share the top five mistakes we see.

  1. Add-backs: These are adjustments that are made to the income statement or tax return to try to determine the true earnings of a business. There are many legitimate non-cash items, discretionary items, and one-time expenses that can be “added-back” to the income statement, but we often see people get carried away and this can cause an inflated value that a buyer can’t get banked.
  2. EBITDA vs. SDE: If you are an owner-operator with under $1 million of annual earnings, you are likely considered a “main street” business and you are probably going to be valued as a multiple of Seller’s Discretionary Earnings (SDE). If you are owned by more of an investor-type, or you are leading only as a high-level CEO with little day-to-day involvement, and have over $1 million of annual earnings, you might be a “lower-middle market” business and you’re going to be valued as a multiple of Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA). Applying EBITDA-based multiples to a main street business will result in a much higher value than it should.
  3. Valuing future earnings: Unless you have an exchange traded stock and analysts following your business regularly, you probably don’t have a consistent enough earnings trajectory to qualify for a Discounted Cash Flow (DCF) model. Your earnings may be great, but in a small-to-mid sized business, there is too much variability from year to year, so historical earnings are the appropriate way to value.
  4. Comparable transactions: The person doing your valuation should have access to comparable transaction data of companies that look and feel like yours to see what they actually sold for (not just the asking price on a website). When analyzing the comparable data, be sure that any outliers are thrown out to avoid “cherry-picking the comps” or your value may be higher or lower than it should be.
  5. COVID-related adjustments: Some businesses had their best year ever (remember all the COVID related signage was produced by someone); and other businesses took a major hit to earnings. We must look at this through the eyes of the buyer and not put too little (or too much) weight on the years that were impacted by the pandemic. We also have to make sure that the appropriate add-backs are taken both on the revenue and expense sides of the equation for non-recurring events.

There are many ways that businesses are valued incorrectly, but these are five of the ones we see most often that result in unrealistic expectations and sometimes money being left on the table. We are proud to report that we track the accuracy of our valuations: we compare our valuation findings to actual sale prices and have found that we are accurate +/- 3%. We promise to always shoot you straight on what your business is worth and never “tickle your ears”. If you want to know what your business is truly worth, please reach out to us for a confidential conversation.