Determining the value of a business is often a complex task and is best done by either a professional VR business intermediary, or a qualified business valuation analyst. Before one can determine the market value of a business, the financial information (profit & loss statements, balance sheet, and tax returns) must be recast or normalized to reflect the true earning power of a privately held business. The recasting of financial statements provides buyers with a common baseline, “Discretionary Earnings (DE)”, to compare earnings from different businesses and calculate the potential earnings after acquisition. Focus on what your company is really worth. Prospective buyers are interested in companies that have value to them. Therefore it is important to have a current and accurate valuation done on your business before the process of going to the market begins.

What is the Business Really Earning?

Small and mid-size businesses, in contrast to large public and private corporations, tend to keep reported net income as low as possible to minimize taxes. Recasting or normalizing of financial statements is a critical tool in presenting the real earnings history of the business to prospective buyers and also to arrive at an accurate value for the business. The recast or normalized financial history, and Discretionary Earnings (“DE”) take into consideration expenses that are owner benefits, non-recurring, or non-operational to calculate the total economic benefit the owner realizes.

What are Discretionary Earnings (“DE”)?

Discretionary Earnings are a measure of the total benefit accruing to the owner of a business. DE is the most common measure of earnings used for a small or mid-sized privately held business because it is the most accurate way to reflect the total owner benefit. Below is a simplified explanation of how DE is calculated. While this looks relatively straightforward, many other factors must be considered. Using a trained and experienced VR professional allows you too confidentially share knowledge regarding how you operate your business, and work together to unlock true value.

DE is calculated as follows (simplified):

+ Pre Tax Net Income (from tax return)

+ Owner’s Salary

+ “Discretionary Expenses” or Perks

+ Non-Cash Expenses (eg. Amortization & Depreciation)

+ Interest Expense

+ Non-Operating Expenses

= Discretionary Earnings (“DE”) 

What is EBITDA?

Earnings Before Interest Taxes Depreciation & Interest. EBITDA is also a measure of earnings and is the most common measure of earnings for larger companies. While EBITDA does add back pre-tax earnings with interest, depreciation, and amortization, it does not add back any owner benefits such as owner’s salary and perks which are typically expensed to a small and mid-size business. EBITDA is an excellent earnings measure for the large professionally managed business where no owner benefits are expensed through the company. When EBITDA is applied to a smaller company the figure does not accurately reflect the total economic benefit since owner benefits are left out of the calculations. For this reason DE is the more common earnings measure for small businesses, a combination of DE and EBITDA are taken into consideration for mid-size business, and EBITDA is the accepted methodology for larger companies.

What is a Valuation?

Each business is unique and therefore demands an approach that focuses on its unique characteristics. Valuation is as much an art as it is science, yet valuation of a business is also a highly technical process. The ability to decide which valuation methodology is most suited to a company’s needs and apply it correctly to get an accurate picture of value requires skill and experience. VR professionals take into consideration the company’s history, ownership, management, and physical facilities. An industry analysis includes structure, background, and opportunity, along with current conditions. Economic conditions and outlooks are taken into consideration as well as the changes in demographic breakdown as it relates to the product or service. Whether an income, market, or asset based valuation approach is taken, knowing you are working with VR professionals throughout the valuation process is important to unlock true value and peace-of-mind. Remember, a properly valued business sets realistic expectations for buyers!