What we generally do not do is just take the last 3 years and do an average. This would be saying that the performance 3 years ago was of equal value to determining performance as the previous year which for most SME businesses (especially those in growth) does not make sense. With Covid, the results of many businesses in 2020/2021 have nothing to do with the future (some up/some down) so a view has to be taken. So there really is no correct answer for this that suits every situation and where the 'art' part of valuation comes in. The key is to keep the purpose of the exercise in mind which is to determine what the current run rate is. Step 1 - Get the accountant's report for the last fiscal year - A good starting point is to look at the operating profit for the last fiscal year's accountant reports. This will have had adjustments done for accruals, work in progress, depreciation and other items that accountants tend to tidy up at the year-end. Step 2 - Compile a list of add-backs for this fiscal year. These will include non-cash expenses like depreciation and amortization, bank interest on long-term loans, any costs that were non-operational to the business including the owners holidays/gym/car/house extension/family member on the payroll but not in business/etc, any costs that were one-off and will not recur like a fire or sometimes an experiment with a trade show and key employee. There are also negative add-backs (or take-backs) like normalisation of the owner's salary to a replacement cost and the same for anyone else in the business who is not being paid a market wage or is being paid through dividends (as they do not go through the P&L), normalisation of rent to a market rate, an estimate of capital refresh costs if the business has capital equipment.
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