Ever felt lost when trying to value a business? Maybe you’ve heard about using earnings multiples, but aren’t quite sure how they work. Don’t worry, you’re not alone and you are about to better understand how to calculate earnings multiple. Many startup founders, investors, and even some marketing leaders find themselves in the same boat.
This guide is designed to help clear up the mystery and give you a solid grasp of earnings multiples. You’ll learn how to calculate earnings multiple effectively. Plus, you’ll discover how they fit into the bigger picture of valuing companies.
Table Of Contents:
- Understanding Earnings Multiples
- SDE: Seller’s Discretionary Earnings
- Calculating the Earnings Multiple
- Considering the Forward Multiple
- Valuation From the Price-to-Earnings Ratio
- Consider Earnings Yield Over Returns
- FAQ
- Conclusion
Understanding Earnings Multiples
Earnings multiples are valuation ratios. They help to compare a company’s market value to a specific measure of its earnings. This measure gives a standardized way to see how much investors are paying for each dollar of a company’s earnings.
Think of it as comparing the prices of similar houses by looking at their price per square foot. We need this standardization when assessing business valuations. So how do we decide which “metric” should be the comparison criteria?
The Basics of Revenue Multiples
Revenue multiples are simple because they use gross revenue figures straight from the income statement. Since revenue multiples only involve one simple annual number they appear more appealing. Some believe applying a multiple to annual gross revenue offers the best approach for understanding potential share price.
Annual revenues cannot reflect how much money the business actually earns. That is why many experts caution that basing the price multiple on revenues does not reflect the health of the business. These revenues also don’t show any mismanagement or indicate whether it has higher than average expenses.
Digging into Earnings Multiples
Most experts believe that earnings multiples are based on how much the business earns annually for its owner. This number will be more telling to how things truly are going. Owner earnings differ from the profit shown on the business year-end income statement or its federal tax return.
It’s critical to distinguish between “profit” and “annual owner earnings”. It will help you understand how to determine an accurate multiple. So we must take different data and approaches when coming to the value of both the revenue and the earnings.
Profit vs. Annual Owner Earnings
Profit shows the bottom line on the business income statement. The business revenue is less than all legally deductible business expenses to arrive at the lowest possible taxable income. Annual owner earnings include all business revenue, but the deductions are revised.
In small businesses, that helps showcase how much the business actually generates for the owner in a normal year. In the financial world this number becomes the north star by showing just how healthy things really are. But let’s get even more granular by looking into sellers discretionary earnings.
SDE: Seller’s Discretionary Earnings
A key figure in valuing small businesses is Seller’s Discretionary Earnings, or SDE. To calculate SDE, recast the year-end income statement with some adjustments. Understanding the steps can give an accurate portrayal of what we have at our disposal.
- Add back expenses that were deducted for interest to appreciation taxes and amortization. This results in what accountants call business EBITDA earnings. This is all before interest depreciation taxes and amortization.
- Add back expenses that benefited the owner directly, such as owner salary and benefits, insurance, and auto use.
- Add back discretionary expenses and contributions or donations that another owner might choose not to incur.
- Add back non-recurring expenses to normalize earnings. This is done by excluding unusual and one-time transactions of the business.
- If SDE has differed greatly over recent years, work with your accountant to create a weighted average. This is how they make sure to factor for all those key figures when calculating value.
Understanding how the SDE is calculated and having your accountant put this number together is one of the smartest ways to look into what a business is doing. Then we move forward to applying this earnings multiple. But let’s dive into it more for all you number loving people out there.
Calculating the Earnings Multiple
Earnings multiples for small business valuations are between 1 and 5. The weakest businesses will have lowest multiples and highest risk and strongest businesses have the highest potential and lowest risk. To start the analysis of this, it will be based on real market forces in your sector.
It can get difficult if the nature of your work or operation falls in multiple silos. Your job in determining that correct level of risk. Because there are so many opinions it comes down to what are the most concrete pieces when using this valuation method.
| Factor | Weakest (1) | Strongest (5) |
|---|---|---|
| Financial Stability | Erratic revenue, high debt | Consistent growth, low debt |
| Market Position | Niche market, high competition | Dominant market share, few competitors |
| Management Team | Lack of experience, high turnover | Experienced, long-term commitment |
| Operational Efficiency | High costs, outdated systems | Low costs, efficient processes |
There’s also some things to consider when investing in a business or evaluating business for investment in general, since valuations of companies in varied sectors can be way off because of the valuation of business growth as it pertains to how much that company is earning.
A great indicator here can be the earnings multiplier, which can standardize the value of $1 earnings, especially compared with the negative growth which can show a company in poor shape, despite it being a riskier invesment overall.
There may also be outside influences when calculating company performance that can impact leverage; for example a company holding larger amounts of debt will most likely have a lower P/E ratio as explained in these leverage considerations from Investopedia.
However it is very important to acknowledge any misrepresentation within company structures as it will likely create risk for prospective investments due to information not being legitimate. You can understand some additional info, policies and terms on these concepts when referring to Investopedia’s Terms of Service and/or Privacy Policy that explain more in depth. Remember, a tool only provides great results in how much information put into it.
Now, I want you to picture that one business, the one that everyone wonders why people do business. People have the wrong understanding so the following example is a helpful example for when it comes to valuations with earnings. So here we are.
An important case study to consider: Gyms
Take for example Gyms with a market position of 4/5 and an excellent rating for management, how do you factor that compared to other types of smaller markets? Gyms generally generate higher return during January. After the New Years rush there may be an immediate higher rate for memberships due to increased sales.
Factoring the yearly earnings into different periods also brings a more accurate view of revenue for that position. To avoid over stating things you must be sure to see what those ebbs and flows actually show over a multiyear average. Now let’s factor forward multiples and if there can even be an improvement into what these numbers generate.
Considering the Forward Multiple
Using historical profits has the advantage of being proven results. Revenue and EBTIDA forecasts are very subjective. Smaller firms might not offer those guidence with good reason.
Historical numbers can include non recurring income items which is not good at understanding the direction. Excluding items to get a clean multiple is so vital. Basing companies to their potential, is the entire story with how people move forward with them overall.
Because all the historical and forward numbers play a key point, we come to these aspects playing into everything that people think about when they do multiples, and those factors change from what to really understand. In short, EV or TEV is when metrics can include the EBIT, EBIDTA, revenues and UCFF (Unlevered Cash Flows, which pre-debt). The opposite side can be equity value which refers to post-debt, that have both net income, levered free cash flow (FCFE), and earnings per share (EPS), which has different influences as they both coincide with enterprise value but work separately.
This understanding also applies to those working on business for themselves; whether seeking new careers for the valuation or wanting to learn how to advertise. It goes to show the levels that some businesses will work, compared to both sides as different metrics as well. Now we take it more towards what matters as comparisons as what should be reviewed more deeply for these situations in a clearer picture for value expectations.
Valuation From the Price-to-Earnings Ratio
Along with indicating if the business expense matches market, one can view values as compared with the Standard and Poor’s 500. Remember that one may expect to put funds into the company for one dollar’s worth. This is sometimes called the price multiple since that’s the ratio that can be spent into returns.
P/E ratio reveals a stocks value when comparied with companies earning since P/E’s is about past earnings. Higher the multiple, pricier relative that could signal. One aspect here that also has value is in company culture where investors view more into those aspects over potential earnings which may impact the evaluation compared against another.
Let’s clear things up with an easier example from these factors on valuation compared towards industries, and the investor expecations. Now this comparison example really should put things to the light, but let’s factor another step that matters even better.
Factoring N/A values.
Some of the most successful initial public offerings in business has involved companies, not giving a N/A reading for earnings per share (EPS). Since no new releases occurred yet to define what the ratio comes too; to find accurate info investors check those results first so make sure info, value is determined into earnings before taking action, which determines value that impacts business as investments over it’s future.
Consider Earnings Yield Over Returns
EPS gets looked at more compared to returns but is secondary since returns show clear values earned. Since high tech has grown but earnings can read undefinied to some P/E may stay like EPS while this will give a very poor yield that is valuable for it’s comparison with investments. Which gives a clearer reason how yield helps in negative readings when returns matter much.
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The end of some sectors depends on ratios and overall performance, much of which relies on the P/E ratio. A better understanding of this helps buyers earn more in many cases.
FAQ
What is an earnings multiple? An earnings multiple is a financial metric that compares a company’s market value to its earnings. It’s used to determine how much investors are willing to pay for each dollar of earnings.
How are earnings multiples calculated? Earnings multiples are calculated by dividing a company’s market value by a specific earnings measure, such as net income or EBITDA. The most common multiple is the price-to-earnings (P/E) ratio.
Why are earnings multiples important? Earnings multiples provide a standardized way to compare company valuations. This is especially helpful when analyzing companies within the same industry.
What are typical ranges for earnings multiples? Earnings multiples vary by industry and company-specific factors. Generally, higher growth companies command higher multiples.
What are the limitations of using earnings multiples? Earnings multiples are based on historical data and don’t account for future growth prospects. Additionally, they can be distorted by accounting practices or one-time events.
How do you determine a company’s market capitalization? A company’s market capitalization is its total market value of it’s outstanding shares of stock which can also be affected by negative growth. It can be calculated by multiplying the current stock price by the total number of outstanding shares. This figure is frequently used in calculating financial metrics, including earnings multiples and the price-to-earnings ratio.
What are some factors that affect valuation modeling and how it can determine earnings potential? A lot of factors affect valuation modeling that help determine a company’s earnings potential; some of those being financial stability, market position, the effectiveness of the management team, operational efficiency, and also growth rate. A comprehensive valuation considers the balance sheet, the income statement, and statement modeling while factoring for qualitative aspects.
Conclusion
All things considered, figuring out how to calculate earnings multiple provides vital insights when trying to evaluate a business’s worth. When viewing your options be certain to have solid, consistent reporting and data.
Having a handle on revenue streams, and understanding forward value versus recent profit reports can help any startup founders or leader make an informed choice. If there is anything to take away though, calculating these earnings will come down to understanding just exactly how accurate everything presents itself, especially company reviews which are worth seeking when needing the proper expectations.
Understanding how investors determine valuation of a company, by considering their equity market, market capitalization, current stock prices, company’s share price, growth rate, and cash flows helps in the long run as well.
