A commonly employed approach to business valuations is the Capitalisation of Future Maintainable Earnings (CFME), which establishes the business's value based on a multiple of its earnings. So, lets delve into the intricacies of earnings multiples and their significance in business valuations.

The CFME methodology hinges upon estimating the business's Future Maintainable Earnings (FME) and capitalising them at a suitable rate. This rate considers various factors, including the business's outlook, risk profile, investor expectations, growth prospects, and specific (and often unique) attributes. Analysing comparable market data is crucial for effectively implementing this approach.

Business valuations can therefore be heavily reliant on FME, which can be derived from measures of earnings such as Net Profit After Tax (NPAT), Earnings Before Interest and Tax (EBIT), or Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA). EBIT multiples can vary significantly based on industry, performance, and the relative risk associated with the subject business. Typically ranging from 0.8 times FME to well north of 5 times FME, EBIT multiples provide insights into the value of a business. In general terms, businesses with an annual turnover of less than $5 million often sell for less than 3 times EBIT, and those with a turnover below $1 million may struggle to achieve a 2 times EBIT multiple. As the turnover surpasses $5 million, businesses become more likely to attain multiples exceeding 3 times. Exceptional qualities that distinguish a business from its competitors are necessary to command a higher multiple.

Of course, different industries exhibit varying earnings multiples, thus it is often difficult to compare businesses across differing industries. Some sectors witness higher multiples, indicating lower perceived risk, while others experience lower multiples, suggesting a higher degree of risk. Additionally, market dynamics and unique circumstances can lead to businesses being sold at bargain prices or premium valuations. Consequently, considering these factors is vital when determining an appropriate earnings multiple and conducting accurate business valuations.

At its core, the earnings multiple reflects the inherent risk associated with a business's ability to maintain its current profit levels. A higher multiple implies lower risk, indicating a greater likelihood of the business sustaining its projected earnings. Conversely, a lower multiple suggests higher risk and uncertainty regarding the business's ability to maintain its profit level.

Wrapping your head around earnings multiples and what they really mean is essential for understanding the intricacies of business valuation. The CFME methodology provides a robust framework for estimating a business’ value based on its earnings multiple. By considering factors such as business outlook, risk profile, growth potential, and industry-specific dynamics, analysts can accurately estimate FME and determine an appropriate capitalisation rate for the business in question. The take-away is this: the earnings multiple is an estimate of the level of risk exhibited by a particular business sustaining a particular level of profitability. Armed with a thorough understanding of earnings multiples, business owners and investors can make well-informed decisions regarding buying or selling a business.