When consulting, Towne Advisory Services principal Ben Towne likes to include a glossary of terms that he provides to new clients. It helps make sure everyone is on the same page. But not everyone has the benefit of that, so here are some key terms that we at Towne Advisory think you should know anytime you’re working with a business valuation professional.
A quick note before you read further. Many of these definitions can be used differently from person to person, but this is the most common use and the way that Towne Advisory Services uses them.
What does comps (comparables) mean?
Comps, also known as comparables, are other companies or transactions that have some similarity to the company that we’re trying to value.
Why are comps (comparables) important?
Just like in real estate appraisal that compares your house to similar, nearby houses that have sold, looking at business comps gives us pricing info based on actual market evidence relying on real buyers and sellers. By using multiples, we can value the subject company by analogy (see below!)
Discounted Cash Flow (DCF)
What does discounted cash flow (DCF) mean?
Discounted cash flow (DCF) is a method to calculate value using future forecasts of cash flow and a risk rate. DCF estimates the cash flow of a business for a certain period of time. DCF uses the risks associated with the business to convert those future cash flows into today dollars.
Why is discounted cash flow (DCF) important?
DCF specifically shows what the effects of the expected changes in the business are going to have on the value of the business. In other words, it specifically factors in the expectations of the future, not just the past operations of the business in coming up with the business value.
What does EBITDA mean?
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. Wow, that’s a mouthful.
In a conversation, EBITDA is sometimes called “operating earnings”.
Why is EBITDA important?
Sometimes EBITDA is used as a proxy for cash flow. It’s useful because it provides comparability between companies that might have very different debt structures, tax positions, and asset ownership.
What does enterprise value mean?
This is not the value of your starship. (Cue groans)
Enterprise value is the operating value of a business as a whole. It can be calculated a lot of different ways, but a popular way is to look at the value of the total assets of a business minus the cash.
Why is enterprise value important?
The enterprise value is often similar to what a third-party buyer might consider the value to be.
What does equity value mean?
Equity value is the amount that the owners of the business have a claim on in the value of the business. It’s just equity.
Like a house, you have to consider what the mortgage is before you know how much value the owner has in the house. It is often not the same as the price that a buyer would pay for the house because of that debt.
Why is equity value important?
It’s the amount a business owner would receive if they sold the business after paying off all of the debts of the business.
What does multiple mean?
A multiple is a measurement of value in comparison, usually, to a financial metric. It’s a way to compare relative value between companies regardless of size and potentially other factors. Example: value divided by revenue when you are thinking about multiple. If the value is $2 and your revenue is $1 then your multiple is 2x.
Why is multiple important?
A multiple is necessary to compare the values of entities that are similar, but not the same. Ben likes to say, “It’s pricing by analogy or valuation by analogy.”
Example: Company A sold for eight times EBITDA. Company B is similar but is growing faster and therefore should have a higher EBITDA multiple.
What does risk rate mean?
The risk rate is a percentage that represents the required rate of return that someone would demand to invest in a business. It’s also called the “discount rate” or “rate of return”.
Why is the risk rate important?
Under the financial theory that risk equals return, the risk rate helps us identify what the value of the business should be based on the amount of profit that a company is expected to earn.
Risk rate can be calculated a lot of different ways, but essentially encapsulates the risk inherent in the business’s industry as well as risks that are specific to that particular business.
Seller’s Discretionary Earnings (SDE)
What does seller’s discretionary earnings (SDE) mean?
Seller’s discretionary earnings (SDE) is EBITDA plus the compensation of the business owner. This is the amount that the small business owner has discretion over how to spend or distribute after all the regular operating expenses are paid.
Why are the seller’s discretionary earnings (SDE) important?
SDE is particularly important for small businesses because the owner exercises so much control over the company’s finances. They can pay themselves whatever they want. To provide comparability between companies, the SDE measurement of earnings removes the effects of that decision making.
Trailing Twelve Months (TTM)
What does trailing twelve months (TTM) mean?
TTM stands for trailing twelve months.
It’s usually used in combination with financial statements or a metric. An example of TTM is trailing twelve months of profit and loss through the end of the year, or TTM revenue through June 30.
Why is trailing twelve months (TTM) important?
TTM is important because it shows a whole year’s worth of operations. It factors in whether seasonality has affected revenue or not.
What does valuation date mean?
The valuation date is the specific date that the value of the business is getting measured. This is drawing a line in the sand about what was known at a certain time and what conditions existed at that point.
Why is the valuation date important?
A valuation project cannot be an ongoing activity; things change in a business all of the time. Therefore, a valuation is a snapshot of a single point in time. We look from the perspective of that date when we do a valuation.
The valuation date is the date that the valuation pertains to, not the date the valuation is issued.