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Multiple of Earnings Business Valuation – Why You Should Use Historical Earnings

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When you value a business based on a multiple of earnings, you have a difficult decision to make. Should you be conservative and use past proven earnings? Or, is it better to make projections about future learning and use that number in your calculation? Business Buyers are paying for the opportunity to benefit from your company's future profits, so basing your valuation of projected future earnings can make sense.

Of course, the future is impossible to predict perfectly so buyers are hesitant to pay based on unproved future earnings.

If your profits have been trending up for the past 3-5 years, projecting that same rate of growth into the future and then applying a multiple to that projected profit may seem like a valid way to go. Here's the problem: In the multiple of earnings method there two variables: the earnings figure you use plus the number by which you multiple the earnings.

Impressive growth the past few years will definitely allow you to justify a higher than average multiple. So your recent growth should be reflected in your asking price through a higher multiple. If you use an earnings figure based on projected future growth and then also apply an above average multiple to those projected profits because of an above average growth rate you have given yourself credit twice for the same positive feature.

Expect a lot of resistance from the buyer.

Also, the best negotiating strategy is to be aggressive when setting your multiple and be more conservative with determining your profits. (And by "conservative" I simply mean using historical, proven profits instead of projected future profits). The buyer can not argue with you over the facts, but they can and will when it comes to future projections.

Also, it pays to be more aggressive when setting your multiple than your earnings. Increasing your multiple just slightly can have a dramatic effect on the overall selling price. If you can justify to the buyer a multiple of 4 instead of 3 it will mean a 33% increase in your selling price. That's a lot easier than providing that profits will increase in the future by 33%.

So when using the multiple earnings method, use proven past earnings because the buyer can not argue with those facts. Then use the highest multiple you can justify. This will give you the best chance of maximizing your selling price. And the entire negotiation process will go smoother because you and the buyer will not have to argue over guessing how much the business will earn in the future.



Source by Patrick Jennings

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