BUSINESS VALUATIONS USING A
MULTIPLIER OF EARNINGS

By Joel G. Siegel, PhD, CPA, Queens College, Marc Levine, PhD, CPA, Queens College, Adrian Fitzsimons, PhD, CPA, CMA, CFA, St. John's University

Available literature abounds with books and articles dealing with the valuation of a
business including accounting and tax practices. The valuation approaches are based on revenue, earnings, net assets, or a combination thereof. The purpose here is not to repeat the widely used methods, such as gross billings, weighted-average earnings, simple-average earnings, capitalization of earnings, capitalization of excess earnings, present value of future cash flows, or fair market value of net assets. Nor is there any discussion of the commonly known adjustment of reported earnings to arrive at relevant earnings for valuation purposes (e.g., adjustment for personal expenses, nonrecurring items, excessive owner salaries, low cost rentals). The following paragraphs deal only with an innovative approach for arriving at the multiplier to a weighted-average adjusted five-year historical earnings. This approach results in greater objectivity, reasonableness, soundness, and support in using a reliable multiplier in business valuation situations. It is superior to the arbitrary, subjective method currently used in practice which has many inherent flaws. This procedure may also be used to arrive at a gross revenue multiplier, which of course, will be less than the multiplier to earnings.

The Multiplier

Determining a multiplier is the most demanding aspect of a business valuation because it is subjective and difficult to defend in court. The approach here is a sound, reliable, and fair way to come up with as objective a multiplier as possible. The technique is uncomplicated and easier to defend, particularly in litigation.

It is commonly known that the multiplier should be based on many factors including risk, growth in earnings or net assets, financial condition, maturity, size, type of customers, geographic location, nature of business, condition of facilities (e.g., modernized computer facilities such as an up-to-date network), degree of competition, pending lawsuits against the company, adequacy of insurance, management quality, staff competency, state of the economy, and governmental and regulatory issues. A multiplier of earnings typically ranges between 0 and 5 with 3 being an average, often used in practice. The multiplier of 3 is generally supported by guidelines of the AICPA, IRS, and court decisions.

The current approach is to subjectively and arbitrarily decide on a given multiplier (e.g., 2) after studying the facts. However, this approach can be improved upon by using a weighted-average multiplier. This is accomplished by weighting the importance of the various factors, positive and negative, about the company. Each factor (e.g., growth in earnings or high quality management) is weighted from 0 to 5. However, unlike current practice which ignores negative values for negative factors in developing a multiplier, -1 to -5 should be assigned to any negative attributes affecting the business. Examples are a pending lawsuit against the firm that it will most likely lose resulting in damages or a government investigation of the company likely to result in penalties.

The Exhibit shows "how to do it" for a hypothetical business where the
sixteen key factors listed relate to that particular business. Different or additional key factors might exist in other business valuation situations. The resulting table provides guidelines for the assignment of the appropriate multiplier, which is then weighted in priority order by importance. The exhibit presents the calculation of the multiplier for the entire business. *

Editor:
Michael Goldstein, CPA
The CPA Journal