Number Crunching

If you’re an entrepreneur looking to move on, the first step along that road is to find out what your business is worth. “Entrepreneurs know what their RRSPs are worth and what their house is worth, but when it comes to their business, they usually don’t have a good idea,” says Bruce Roher, a partner and leader of the business valuation practice at Fuller Landau LLP in Toronto.

There is, in fact, no standard way to determine a business’s worth. But the key principle is simple: Buyers are interested in purchasing your company because of its potential for future profits. As a result, valuators generally apply a multiple, either to earnings before interest, taxes, depreciation and amortization (EBITDA) to reflect a company’s potential cash flow, or earnings value (EV), in order to reflect the future income-generating potential.

Whether the multiple is applied to EBITDA or EV tends to depend on both the nature and the size of the business being valuated, says Michael Casey, a chartered business valuator and principal with chartered accountancy firm Collins Barrow in Halifax. A multiple of EBITDA is usually for businesses requiring a lot of capital reinvestment (manufacturing, for example). A multiple of earnings works better for service companies that don’t require a lot of equipment or for smaller operations because it’s a slightly less complex calculation. If a company isn’t yet profitable but has plenty of potential, valuators sometimes use a multiple of revenues/sales rather than earnings.

Sounds simple, right? Multiple X EBITDA or EV = business value. But that’s only the beginning. The fact is that a company’s past cash fl ow and earnings don’t necessarily reflect what will happen in the future. For that reason, the multiple being applied has to be adjusted to reflect the potential upside or downside of a specific industry. In order to come up with the correct number, valuators perform complex calculations that take into account the value of all of the assets (both physical and intangible), as well as a range of other considerations, from the general state of the economy to the industry landscape. “We consider all the positive and negative factors affecting a company’s ability to sustain future earnings,” explains Roher. “The higher the risk, the lower the multiple. It’s an inverse relationship.”