A Valuation Metric Just for Small Businesses

Most valuation professionals would hesitate to use a complicated discounted cash flow analysis to estimate the value of a mom-and-pop restaurant. And they’d likely frown on using a price-to-earnings multiple derived from publicly traded restaurant chains. Why? Both methods are generally considered “overkill” for estimating the value of a small family-operated eatery.

As this example illustrates, traditional valuation models don’t always work for small businesses and professional practices. Instead, valuation advisors typically turn to an alternate metric: seller’s discretionary cash flow (SDCF).

Public market data is less relevant for a small business that functions primarily as a “job” or steady source of income for its owner(s). Entrepreneurs go into business for different reasons than investors buy public stock. Small business owners appreciate the inherent values of being their own bosses, employing family members, passing on a legacy to heirs and expensing discretionary items (such as country club dues, business trips, company cars and season tickets to their favorite sports teams). In exchange for these benefits and perks, small business owners are generally happy to build “sweat equity” in their ventures.

Calculating the Metric

When looking to obtain a value estimate of your small business or professional practice, it’s important to recognize the nature of the enterprise. Is it a pure investment or a job that provides income and discretionary perks to you, your family and friends? If the latter description rings more true, then SDCF could be a more meaningful metric of what the business is worth to you.

Calculating SDCF starts with earnings before taxes. Then you adjust for:

• Non-operating income and expenses,
• Unusual or nonrecurring income and expenses,
• Depreciation and amortization expense,
• Interest income and expense,
• One owner’s total compensation,
• Above (or below) market rates paid to (or received from) related parties, and
• Discretionary expenses.

It’s important to identify and disclose everything that could be relevant to a potential buyer, including all discretionary expenditures that you incur in the business. Although these could very well be legitimate expenses, such as business related meals with customers, they might not be expenses that a new owner would choose to incur. You need to document all benefits for the owner and other employees so potential buyers can see not only what benefits are available, but also what the approximate annual costs of these benefits are.

Once your valuation professional has calculated SDCF, you can compare the business to other similar companies in your industry — that is, those with comparable size, financial performance and geographic locations — that have recently been sold. You and your valuation advisor should be able to take each comparable transaction and calculate its SDCF-to-value multiple. These pricing multiples will give you a good sense of what your business might be worth in the current marketplace.

Recognize Dual Elements of Value

SDCF multiples derive value from all of the cash flows that are available to an individual business owner. Unlike methods used to value businesses that are pure investment plays, the SDCF method captures an owner’s return on investment and reasonable annual compensation. Both elements are usually quite valuable to the owner-operator of a small business.

Small business buyers are often focused on providing sufficient income for their livelihoods; this is similar to dividend returns that stock investors receive each year. Conversely, sellers are interested in how potential buyers will perceive their respective businesses as an investment; this is similar to the appreciation in value that public stock investors hope to achieve when they someday sell their stocks. Over the long run, every buyer eventually becomes a seller, regardless of the size and marketability of the business.

Small businesses can be hard to value, because they don’t fit the traditional valuation model that calculates a simple return on investment. That’s why valuation professionals view SDCF as a meaningful metric for both sellers and buyers of small businesses. As mentioned, they often choose it over more sophisticated methods — such as discounted cash flow techniques and stock pricing multiples — that are based on public stock returns.

Go With a Pro

Whether you’re buying or selling a small business, it’s important to find a qualified, experienced valuation advisor who can calculate a reasonable value estimate of the company in question. Your CPA can assist in the process by helping you capture and present the right financial data.

This article appeared in Walz Group’s August 24, 2022 issue of The Bottom Line e-newsletter

Keywords-Small Businesses, Valuation, Seller’s Discretionary Cash Flow