For small to medium-sized businesses (SMEs), Seller’s Discretionary Earnings (SDE) is the most relevant measure when valuing a business. This is particularly true in New Zealand, where 97% of businesses have fewer than 20 employees. Using SDE provides a clearer picture of the business’s earning potential.
What Influences Earnings Multiples?
The range of SDE multiples can vary significantly, even within the same industry. Here are the key factors influencing these variations:
1. Industry-Specific Risks and Characteristics
Each industry has its unique risk factors, which can greatly influence the earnings multiple of a business:
- Ease of Entry: If it’s easy to start a business in a particular sector, existing operators may hold less intangible value, leading to lower multiples.
- Economic Cycles: Industries like construction or tourism experience cyclical ups and downs, making businesses in these sectors riskier investments.
- Transferable Goodwill: Service-based businesses (e.g., hair salons, consultancy firms) often rely on the owner’s personal relationships and reputation, making it harder to transfer value to a new owner.
- Franchise Support: Quality franchise businesses offer support and reduced risks for buyers, often resulting in higher earnings multiples.
2. Size of the Business and SDE
The size of a business’s SDE is a major factor in determining its earnings multiple:
- Larger SDE, Higher Multiples: Businesses with higher SDEs are often seen as more stable and profitable, leading to higher earnings multiples.
- Intangible Assets: As SDE increases, the proportion of intangible assets in the total selling price tends to rise, further boosting the multiple.
3. Barriers to Entry and Competitive Advantages
Barriers to entry can significantly impact the perceived value of a business:
- Skill Requirements: Businesses requiring specialised skills or qualifications (e.g., legal practices, medical clinics) have fewer potential buyers, which can affect the multiple.
- Location: Prime locations can command a premium, as the advantage of an established presence in a high-traffic area is highly valued.
- Brand Strength: Strong, established brands often increase the business’s value, resulting in higher earnings multiples.
4. Terms & Conditions of Sale
The terms and conditions attached to the sale of a business can influence the earnings multiple:
- Vendor Support: An accommodating settlement with strong vendor support can reduce buyer risk, making the business more attractive and potentially increasing the multiple.
- Favourable Lease Terms: Long-term, flexible leases can add value and enhance the appeal of the business.
5. Lifestyle Factors
For many SME buyers, lifestyle considerations play a significant role:
- Work-Life Balance: Businesses that offer a favourable lifestyle, such as cafés open only 5 days a week, can command higher multiples compared to those demanding more time.
6. Market Trends and Growth Potential
The growth or decline of a business and industry trends have a substantial impact:
- Consistent Growth: A history of steady growth or increasing profitability will often result in a higher multiple.
- Industry Trends: A business aligned with positive market trends is more likely to command a higher multiple, as buyers see greater future potential.
7. Buyer and Seller Motivation
Human factors can significantly influence the final sale price:
- Motivated Sellers: Owners looking to sell quickly due to personal reasons might accept a lower multiple.
- Enthusiastic Buyers: Buyers keen on a specific location or industry may be willing to pay more than the going rate.
Using Market Data to Understand Earnings Multiples
Market data offers valuable insights into how similar businesses are valued in the open market. It provides:
- A benchmark for earnings multiples within specific industries.
- A view of the range of multiples paid for comparable businesses.
- A reality check, ensuring valuations reflect market conditions.
Note on Valuation Methods
It’s essential to recognise that not all businesses are best valued using earnings multiples. In some instances, a net asset-based valuation or another method may be more appropriate. Always consult with a professional to ensure the chosen valuation approach accurately reflects the business’s circumstances.
For more insights or to access comprehensive market data, visit Bizstats.report.