Multiple of Earnings
Multiple of earnings is one way to value a business. It involves multiplying a company’s profits by a certain number to end up with a value. “Multiple of earnings” multiplies the “earnings” (or income or profit) of a year, or average of years, in order to come up with a figure representing the company’s worth in a sale.
In most cases, EBIT (Earnings Before Interest and Taxation) is the amount used for this first earning’s number. However, for companies ranging from several million dollars to several hundred million dollars, the “multiple of earnings” is often equivalent to the multiple of EBITDA (Earnings Before Interest, Taxation, Depreciation and Amortization) instead of EBIT.
Determining what number the current profits are multiplied by depends on the stability of the business. For example, a company that’s very well-established, with a strong hold on the market, that can operate under or with an entirely new team might bring in a multiple of 8 to 10 times current profits. On the other end of the spectrum, a small, individualized business that relies solely on one service provider might acquire a multiple of 1 times current profits. In reality, most businesses are sold for a multiple of 3 to 5 times the current profits.
Using Multiple of Earnings for Business Valuation
There are many different methods for business valuation; however, the central method calculates multiple of earnings. You should consider some of the following questions before evaluating a company:
- Is a seller using pre-tax earnings or post-tax earnings? If you’re the buyer, remember to include your tax rate not the seller’s. If you are the one selling, pick which year of earnings to base the valuation on. Many sellers will use the current year’s earnings even if the second half has not occurred yet. Simply multiply the first half of the earnings to project through the year.
- Do you use past profits or projected future earnings? Most appraisers recommend using the profits from the last three years to establish more credibility in the sale; however, you can weight the more recent years more heavily, if the profits are increasing each year, to suggest projected income.
- Are the current earnings an anomaly or are they consistent? Many owners will sell after a spike in profits, but you should evaluate the business risk by looking at a more thorough review of a business’s earning history.
- What’s the business’s climate? How established is the business? Can it run without the current staff or leadership team? Are there competitors moving in that have yet to affect the company’s earnings? Is the economy growing or shrinking? What is the impact of new technologies on the industry?
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There are many factors to consider when evaluating a company, and many aspects to include when determining the “true” value. Looking at the profits solely will not give you the full picture of a company’s worth.