The Impact of Levels of Earnings on a Business Sale
When valuing a business, there are three general approaches to determine value: the Asset Based Approach, the Market Approach, and the Income Approach.
Within each of these approaches there are various Appraisal Methods used to determine value. The Asset Based Approach method adjusts assets from their reported book value to their in-place market value utilizing cost and market data. The Market Approach method produces a value using comparative ratios derived from past transactions of closely held and/or publicly held companies. The Income Approach method capitalizes some level of earnings into a value using a cap rate, discount rate or multiplier.
A key component of the Income Approach and the Market Approach is the level of earnings which will be converted into a value using a capitalization concept or comparative valuation ratios concept.
What Discretionary Earnings Are Used to Value a Business?
There are standard levels of earnings typically used by appraisers, business brokers, and investors. They include the following:
Discretionary Earnings – The earnings of a business enterprise prior to the following items:
- Income taxes
- Nonoperating income and expenses
- Nonrecurring income and expenses
- Depreciation and amortization
- Interest expense or income
- Owner’s total compensation for those services which could be provided by a sole owner/manager.
- EBITDA – Earnings before interest, taxes, depreciation and amortization
- EBIT – Earnings before interest and taxes
- EBT – Earnings before taxes
- ATE – After Tax Earnings
- Dividends – Cash flow available after payment of all operating expenses, taxes, and increases or decreases for capital expenditures and working capital.
The level of earnings used on all CBB business profiles is known as Discretionary Earnings described as above. On occasion, our business profiles will show earnings as Cash Flow. When Cash Flow is shown as the level of earnings, it means that the real estate is being sold along with the business. When the real estate is owned by either the shareholder personally or by the corporation, rent has been imputed as an operating expense in calculating Discretionary Earnings to separate the earnings attributable to the real estate from the earnings attributable to the business. Cash Flow then represents the Discretionary Earnings plus the imputed rent to reflect the total amount of funds which can be used for owners’ salaries, asset replacement, and debt service. For further clarification of this issue, ask your CBB business broker.
