For owners of privately-held businesses, understanding the value of your business is critical for planning the business's future and your financial future. Whether you are planning to borrow money, attract minority investors, sell the company in its entirety, or gift ownership in the company, it is important to understand what your business is worth.

In valuing privately-held companies, there are three primary approaches.

#1: The Income Approach

The income approach consists of estimating the future cash flows to be generated by the business, and then converting them into present value. However, the income approach requires clear expectations of future performance, uses complex financial concepts, and is highly sensitive to inputs, which makes it a suboptimal approach for valuing many privately-held companies.

#2: The Asset Approach

The asset approach is used to estimate the value of a business by subtracting the value of its liabilities from the value of its assets. The asset approach can be useful in valuing holding companies, real estate, and highly capital-intensive businesses. However, the asset approach does not consider the company’s future earnings; as such, it is rarely used in valuing profitable operating companies.

#3: The Market Approach

The market approach uses sales of comparable companies and market information for publicly traded companies to determine the value of a business. To do so, the values of the comparable companies are compared to revenue, profit, and other metrics to derive multiples. After evaluating how the business lines up against comparable companies, these multiples are applied to the metrics of the business being valued to determine its value.

This approach can be an effective way to value privately-held companies, since it is does not require future projections, is relatively simple, and reflects the real-world market for the business being valued.

Nevertheless, using the market approach brings up a key question: which metric should I use?

Using the Market Approach – Which Metric is Right for Your Business?

The market approach generally relies upon relationships between the enterprise value of a business and its key financial metrics.

Here are some of the most common metrics used under the market approach:

  1. Earnings before Interest, Taxes, Depreciation and Amortization (EBITDA): EBITDA is the most common metric used in valuing profitable privately-held operating companies. Interest and income taxes are added back, as they reflect the impact of financing, organizational, and tax decisions, which are unrelated to the company’s operations. Depreciation and amortization are added back because they are non-cash expenses. EBITDA represents a proxy for operating cash flow of the business prior to the consideration of fixed asset investments, debt service, and income taxes.

    There are also a couple EBITDA-related metrics which can be applicable in certain cases:
    • Earnings before Interest, Tax, and Amortization (EBITA): EBITA is the same as EBITDA, except depreciation is not added back. EBITA can be an appropriate valuation metric for businesses that require consistent and significant capital expenditures to support the operations of the business. In these cases, depreciation is closely associated with the requirement of cash on an annual basis and is not added back as a result.
    • Earnings before Interest, Tax, Depreciation, Amortization, and Rent (EBITDAR): EBITDAR is the same as EBITDA, except rent is also added back. EBITDAR can be an appropriate valuation metric for businesses in sectors such as hospitality, hotel, and transport, in which businesses rely heavily on facilities and/or vehicles. In adding rent expense back, EBITDAR controls for the decision to own or rent these assets so that businesses are compared on an apples-to-apples basis.
  2. Revenue: Revenue is often used as a metric in valuing companies that are not profitable. Revenue multiples are especially common in valuing start-ups, especially in the tech industry, which are in the growth stage and have not yet achieved consistent profitability. In these cases, earnings-based metrics would not be applicable, as there are no earnings. Instead, companies are valued based on multiples of revenue, with the assumption that they will eventually be profitable as they grow and become more efficient.
  3. Industry-Specific Metrics: Within various industries, there are key financial metrics and performance indicators used in valuing companies. For example, for software as a service (SaaS) companies, annual recurring revenue is a key metric. For subscriber-based services, the number of subscribers is a key metric. And for inpatient care facilities, the number of beds is a key metric. Depending on the industry you are in, it may be beneficial to identify industry-specific metrics to use in valuing your business.

Using the market approach provides owners of privately-held businesses with a simple method for valuing their business. EBITDA is the most common metric used under the market approach, but there are other metrics that can be used as well. When applying the market approach, it is also important to evaluate your company against comparable companies to determine the proper multiples to use. Valuing your business may seem daunting at first, but using the market approach, it doesn't have to be so scary.

If you have any questions or would like additional information, please contact a member of our Business Valuation group.