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Value: John Warrillow

The math behind the multiple Add to ...

Have you ever wondered what kind of multiple of earnings a business like yours would sell for?

It’s a fair question, but focusing on your multiple is a little bit like a hypertensive person focusing on his or her blood pressure report. To really understand the number – and to manipulate it up or down – you have to know the calculation.

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Financial buyers acquiring a company will usually do some math to figure out what they are willing to pay today for the rights to your business’s future profits.

We’ve all made a similar calculation. For example, you may have decided in the past to invest $100 in a bond that offered 5 percent interest a year. In other words, you decided to spend $100 on something that would be worth $105 a year later.

To see how this math affects the value of your business, imagine you have a company that you expect to generate $100,000 in pre-tax profit next year. Buyers looking for a 15-per-cent return on their money in one year would pay $86,957 ($100,000 divided by 1.15) today for $100,000 a year from now.

When putting a value on a business, financial buyers typically take in not only the next year’s profit, but all expected profits in the foreseeable future. For every year into the future that buyers must wait to get their profit, they “discount” the future profit you are projecting by the rate of return they expect.

For example, if you project your company will generate $100,000 of profit a year for the next 10 years -- kind of a stupid assumption, but I’ll use it to simplify the example -- here's how it would work.

Financial buyers would “discount” the $100,000 of profits in year one by 15 per cent, valuing it at $86,957.

Given that they would take off 15 per cent for each year they have to wait for their money, the second year's $100,000 in profit would be worth $75,614. Year’s three $100,000 would be worth $65,752 and so on until you would reach the tenth year's profit, which would be only $24,719.

To figure the value of the business using this methodology, you simple add each year’s “discounted” profit up. Therefore, an investor looking for a 15-per-cent return on his or her money would pay $501,878 (in MBA parlance, this is called “net present value”) today for a business that he or she would expect to generate $100,000 a year for the next 10 years.

The relationship between risk and return

The price an investor is willing to pay for your business relates to how risky he or she perceives your future stream of profits to be: The riskier the investment, the higher the return an investor will demand.

“Every potential buyer – no matter what valuation method they use – will consider both growth and risk in determining how much they are willing to pay”, says Brad Davidson, president of SPARDATA Value Advisors, a business valuation firm near Washington, “and sometimes the buyer and seller have different motivations and may not agree on what is risky.”

Today, investors can put their money into relatively safe bonds and get a few percentage points of return, or they can buy a balanced portfolio of big-company stocks and expect perhaps a 7-per-cent or 8-per-cent return over time.

But when buying one relatively risky business rather than a balanced portfolio, investors will expect a much higher return on their money.

For illustrative purposes, imagine an investor is looking for a 50-per-cent return for buying your business because he or she deems your future stream of profits to be very risky.

Now the same business projected to generate $100,000 for the next 10 years is only worth $196,532 -- less than half as much.

The only difference is the buyer has placed a deeper discount on your future stream of profits because they see them as risky.

To increase your multiple, you have to make the case to a buyer that your future stream of profits is relatively safe.

Tomorrow: How your company’s projected growth changes its value

Special to The Globe and Mail

John Warrillow is a writer, speaker and angel investor in a number of start-up companies. You can download a free chapter of his new book, Built to Sell: Creating a Business That Can Thrive Without You.

Join The Globe’s Small Business LinkedIn group to network with other entrepreneurs and to discuss topical issues: http://linkd.in/jWWdzT

Follow on Twitter: @JohnWarrillow

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