Marine Industry Business Specialist Mick Godwin Explains
When it comes to valuing your business, there are several methods we can use. However, most small to medium businesses apply the capitalisation of future earnings method. If the capitalisation of earnings does not demonstrate the most value for your business, there are other methods, including net tangible assets, cost to create, industry methods, and liquidation methods. But, in this article, we’ll focus on the capitalisation of earnings, which at its core is a formula.
My name is Mick Godwin, and I value, prepare and sell businesses every day; in this article, I discuss the most common method used to calculate business value. To simplify the term’s meaning, you can think of it as the relationship between earnings multiplied by a number to represent the business’s value. Two significant factors heavily contribute to the capitalisation formula, they are historical normalised earnings or profits and an owner’s involvement in the business.
Firstly, normalised earnings. This refers to the total actual earnings that an owner takes from the business, whether they work in it or not. We use historical normalised earnings to estimate future earnings (I’ll explain the term ‘normalised’ shortly); not surprisingly, the more money a business makes, the higher its potential value. The second part of the formula is considered the multiplier (or cap rate), usually between 0.5 – and 4. This number is influenced by many factors but is heavily affected by the owner’s involvement. Generally, the less the owner is involved, the higher the multiplying number and the more the business is worth. Other contributing factors include security on the place of business, plant and equipment and any further investment required.
Normalised earnings are a way to show actual earnings by adding back some expenses that are not directly related to the business operation. Or removing and adjusting any income that is not associated with the business. Two approaches are used to determine the two elements of the formula. These are referred to as EBITDA and PEBITDA.
EBITDA: Earnings Before Interest Tax Depreciation and Amortisation.
PEBITDA: Proprietors Earnings Before Interest Tax Depreciation and Amortisation.
EBITDA refers to an under management business, and PEBITDA refers to an owner-operator business. So, to explain it another way, if you are involved in your business and consider yourself a key staff member, your value approach would be a PEBITDA approach. However, if the company is under management, or you have little involvement and are not considered critical, then I would use an EBITDA approach to your business.
A business using a PEBITDA approach to value will usually sell for between 0 – 2 times earnings. A business that can use an EBITDA approach can sell for 2-3 times earnings and sometimes up to 4 times earnings.
For example, if an owner works in their business full time and between their payslip and end of year profits, they earn $200,000 then ignoring all other factors (and there is a lot!) That owner could expect a sale price of up to $400,000 using the capitalisation of earnings method. On the other hand, if a fully managed business earns the owner $200,000, that business may sell for up to $600,000 or more. Of course, a good business broker will know to look at numerous other factors as business value is far more complex than a rule of thumb approach, but you get the idea.
Factors that can impact business value are as varied as the wind and seas. The main idea this article has focused on is that the relationship between what you earn and how much you’re involved will have the most significant impact on what most businesses are worth on the market, under $2 million. The level of success you and your broker achieve in the sale of your business will be largely dependent on a combination of the broker, the brokerage firm and your commitment to sell.
If you would like to know more about what’s involved with selling your business or what you can do to increase the value of your business, then call or email me directly using the details below. I’ll be happy to help you become clear on your next step to exit your business successfully.
Mick Godwin Ph: 0416 638 154 mickgodwin@benchmarkbusiness.com.au
Published in print July-September 2022
