When lenders value a business for an SBA loan, the Small Business Administration does not require that the business valuation include any specific business valuation method. However, the SBA does provide lenders a set of valuation methods that are termed “acceptable.” These acceptable SBA business valuation methods are summarized below:
Gross Revenue Multiplier – This valuation method falls under the market approach, which determines business value by comparing the target company to sales of businesses that are similar. Central to this approach is the Principle of Substitution, which states the economic value of something will be equal to the cost of acquiring an equally desirable substitute. In this case, the SBA promotes using the broadest level of company performance, gross revenue. The revenue multiplier is determined by comparing the target company to a set of transactions of comparable companies: a group of transactions. The analysis of the target company and how its condition and performance compare to the sold companies (the group) will guide and support the analyst in determining an appropriate revenue multiple.
Cash Flow Valuation – This method also falls under the market approach and is very similar to the Gross Revenue Multiplier method above. Cash flow in this instance refers to the cash available to the owner; it is also commonly referred to as discretionary cash flow or discretionary earnings. By using discretionary earnings, the analyst is working with a more refined and important measure of company performance than gross revenue. After all, earnings to the owner/investor is the most important factor to the owner/investor. Once discretionary cash flow is known, the process is the same as the gross revenue multiplier method. One must determine how desirable the target company is relative to the companies in the group of comparable company transactions. Once that is understood, a cash flow multiple is chosen based on the evidence and then applied to the target’s cash flow to arrive at a business value.
Adjusted Book Value – This valuation method falls under the asset approach and is pretty straightforward in its application. It involves adjusting the tangible and intangible assets and liabilities on a company’s balance sheet from their book value (hence, the name) to their actual fair market value as of the valuation date. Once the current values of all assets and liabilities are known, business value is determined simply by subtracting liabilities from assets.
Discounted Future Earnings – This valuation method falls under the income approach, and is perhaps the most complicated of the valuation methods to perform. Central to this approach is the Principle of Substitution: value will be equal to the cost of acquiring an equally desirable substitute. The method is applicable when the future growth of a company is not expected to be steady. It involves forecasting growth in earnings in years to come until growth levels off and becomes steady. Once future earnings are expected to grow at a steady, long-term rate, those earnings are capitalized. The present value of all future earnings is calculated by discounting (hence, the name) those earnings back to the present. The reliability of the resulting value depends on one’s ability to forecast future earnings and to correctly determine a discount rate.
Capitalized Adjusted Earnings – This method, like discounted future earnings, falls under the income approach. It is applicable when a company is expected to grow at a stable, long term rate. In order to determine value, one first must make any required adjustments to historical earnings, generally only the most recent three years. Then, those results are given weightings, resulting in a weighted average earnings figure; this figure represents typical company performance and is the basis for anticipated future earnings performance, when growing at a steady long-term rate. This weighted earnings figure is then capitalized in order to determine company value: capitalizing the earnings figure tells us the present value of all future earnings, i.e. the business value.
These five valuation methods are termed “acceptable” for lender use by the SBA. When an independent business appraiser is performing an appraisal for an SBA loan, he/she may choose from one of these five methods or he/she may choose to work with other commonly accepted valuation methods, as the valuator deems appropriate given the assignment at hand.