Seller’s Discretionary Earnings
In this method, the Business Appraiser creates a cash flow worksheet derived from historical income statements or preferably tax returns. The Appraiser analysis the financials and add backs interest, owner’s compensation, any non cash related expenses as well as “non essential business expenses” to the bottom line.
Interest is added back to the bottom line if the debt will not be passed on to the buyer. This applies to asset purchases, but not stock purchases. The owner’s compensation is added back to the bottom line since this is a benefit the new owner will acquire if they are hands on. For a passive buyer they will discount the owner’s compensation based on the market price for hiring an employee to handle the seller’s duties.
Two common non cash expenses are depreciation and amortization. Even though no cash is involved these are legitimate expenses a business owner may use. Adding back the non essential business expenses requires a conversation with the business owner. These are typically expenses used to minimize taxes and are not required to run the business effectively or efficiently. A common example is travel expenses for a business such as a restaurant that does not offer delivery or catering. The owner expenses trips where they discuss business, but we all know a trip to Las Vegas or New York isn’t typically required to operate a restaurant in the Florida Panhandle.
A completed cash flow worksheet with the add backs shows a potential buyer what they can expect as their true future cash flow keeping everything constant. Of course business is never constant so a buyer will consider other items such as stability of cash flow, time value of money, and current market conditions when creating their projected owner’s benefits. However, for the purpose of this article we will project a constant cash flow for the buyer.
Once everything is complete the appraiser will apply an industry standard multiple to the seller’s discretionary earnings and adjust it based on their analysis of the business as well as current market conditions. Lastly, the cost of current hand’s on inventory is added to the valuation to calculate the final appraised value.