Business Valuation based on a profit multiplier

Using a profit multiplier, the value of the business is calculated by multiplying its profit. For example, if your company’s adjusted net profit is $100,000 per year, and you use a multiple like 3, then the value of the business will be calculated as 3 x $100,000 = $300,000.

From the potential buyer’s viewpoint, this means that as long as the business continues to make profits at the same level, they will get roughly $100,000 per year for the $300,000 investment, i.e. a 33% return.

After three years they will get the full return on the investment. Compared to the bank or other investments this is a highly profitable return. The profit multiplier method is also known as the Price to Earnings or P/E Ratio, the price being the value of the company and the earnings being the profit that the company generates.

Determining the multiple

If pre-tax profit is used, commonly applied profit multiples for small businesses would be between 1.5 to 3 and occasionally, above. These multiples are industry related.

Obviously, the multiple that you use has a huge effect on the valuation of the company. A larger business with a consistent track record of good profits where the owner operates in a managed or semi-managed style is likely to value by a higher profit multiple.

EBIT and EBITDA

For some companies, it is wise to make further corrections in a profit multiplier calculation, such as EBIT or Earnings Before Interest and Tax.

This is the adjusted profit that your company makes without the effect of tax and interest. The EBIT gives a demonstration of the earnings of the business without the destabilising effect of debts or surplus cash balance.

You may be thinking why are valuations calculated without any tax?

The reason is that once the company is either acquired, or part of a private investors portfolio, the tax position as a whole may be different. The valuation is agreed based on the profit after tax and as long as both seller and buyer understand and settled for this, there shouldn’t be any problem.

EBITDA or Earnings Before Interest, Tax reduction, Depreciation and Amortization are similar to EBIT. In addition, it explains that profit or adjusted profit is without the effect of any corrections due to the devaluation of assets (depreciation) or repayment of any business loans.

Happy to discuss what multiplier would apply to your business; please keep in touch.