There are many popular business valuation methods used by appraisers, accountants, bankers, brokers, buyers, and sellers. Here is a partial list of valuation techniques that you will hear about during your acquisition search:
- Asset Value
- Future Potential Value
- Discounted Cash Flow Value
- Return on Investment Value
- Times Sales Value
- Comparable Business Selling Price Value
- Synergistic Value
- Established Industry Value
- Intrinsic Value
- Multiple of Earning Value
- Liquidation Value
- Replacement Value
There is no one way to place an exact financial value on any business.
Personally, I am a financial buyer:
When I buy a business, I focus on how much money the company will earn for me. I do not care much about the other valuations.
It must be a business I like and at a price that allows me a fair return on my time and money.
High asset value and a high appraised value may be of help in the financing, but the Return on Purchase Price (ROPP) is the most critical number to me.
This is also referred to as a multiple of earnings valuation method.
My minimum goal is a 20% or more return.
Say a company has cash flow of $90,000 and an asking price of $500,000. If I paid $90,000 I would have current cash on cash return of 18% on my investment. ($90,000 / $500,000 = 18%)
Example 1 – A fast growing company
Many professionals will argue that businesses with high revenue growth rates should be worth a premium.
Example 2 – Companies high in asset value and corresponding low cash flow
In these situations, the seller will always base the asking price on the value of the assets and not the value of the cash flow. Don’t fall for it. Pay only what it will return to you based on the cash flow.
Example 3 – A company with few assets and correspondingly high cash flow
Assume a business has very little in assets, yet has large net income. These types of businesses can be much more difficult for you to get bank financing for. Lenders like to make loans that are secured by hard assets. Very few banks are willing to make loans based solely on the cash flow of the business without being supported by hard asset as collateral. More seller financing may be required.
Example 4 – Sellers will try to value the company based on future potential but using past performance figures
The seller will tell you how much better the business will do over the next couple of years, and that the business is worth a premium because of this potential. Don’t fall for this blue sky approach.
Example 5 – The seller wants a high price for his business regardless of legitimate valuation method
Don’t spend much time with this seller. Make your offer to purchase at your valuation, wish the seller well, and ask him to call you if he ever reconsiders his price.
Factors I Consider in Valuing a Business
- Consistency of Earnings – Does the business consistently make similar profits year after year? Be very wary of a business that is showing a big profit in the current year with only a marginal profit the prior year.
- Customer Concentration – If the business is dependent upon a few big customers, use a low multiple. There is a lot of risk for a business that is dependent on one or two big customers.
- Growth Rate of Industry – Is the industry declining, stable, or growing?
- Seasonality – How do seasonal fluctuations affect the cash flow of the business?
- Barrier to Entry – How hard is it for new competitors to start up?
- Location Relative to You – If the business is close to your home, then it might be worth more than if you need to have a long commute.
- Business Location – Is the business in a great location for its customers? If the business has a prized location, then expect to pay a little extra.
- Competitor Risk – Is a big competitor putting on the pressure?
- China Threat – Can the company’s products be produced overseas less expensively?
- Technology Risk – Are there new technologies that might pressure this company’s products or render them obsolete?
- Number of Interested Buyers – Are you the only bidder for this company or are there a lot of other interested buyers?
- Seller Motivation – If the seller is really motivated to sell, you may be able to use a lower multiple.
- Terms – Is the seller willing to provide generous payment terms? Good financing terms may increase the overall value of the business.
As you can see, there are always a lot of factors that determine the value. As I’ve said above, I am personally a financial buyer, as are most of us here at the Institute. I think it’s the most concrete “black and white” method of estimating the return on your investment and making sure your time and money are well spent on an acquisition. But even if we all used that method, a business can still be worth more to me than it is to you and vice versa.
For example, let’s say that you are in the insurance industry already and have your own client list. You may be willing to pay a premium price to purchase an insurance agency because when you blend its revenue with the revenue from your existing client list, your ROI is much better than someone who is just looking to buy that insurance agency by itself.
There can be other personal factors as well. We recently worked with someone who knew he was going to be losing his job soon (his company was falling apart), so he needed to move fairly quickly. He was more willing to pay a higher price, because he knew that he was going to need income soon.
Nothing wrong with either of those scenarios… like we said at the beginning:
“Different businesses are worth different amounts of money; to different people, at different times, for different reasons”
|SALES||Tax Return||Tax Return|
|Construction Sales||63, 625|
|GROSS Sales:||$890,108||$907, 443||$995,437|
|EXPENSES – General & Administrative||401,098||447,686||446,760|
|MISC – Adjustments|
|Real Estate – Mortgage/Rent Adjustments ($4,814/yr)||(4,814)||(4,814)||(4,814)|
|(Real Estate @ $70K minus 20% = $56K @ 6% for 20yrs. = $401.20mo. …… $4,815.20 annually)|
|Insurance – Keyman Life||10.748|
|3 salaries = $51,000 each||153,000||153,000||153,000|
|Cash available to new owner:||$199, 457||$200,715||$182,671|
|Wage add-back ($75,000)||(75,000)||(75,000)||(75,000)|
|Adjusted Annual Cash-flow||$124,457||$125,715||$107,671|
- Standard EBITDA value/profit adjustments
- Other miscellaneous add-backs
- An interesting owner’s salary add-back scenario
We will explain each. To simplify, we will just focus on 2016, but the same principals will apply across all years
- First, you see that they only had a net income (profit) of $24,313. Not a whole lot, which would at first make you think that this business isn’t worth much of anything. But let’s keep moving down and find the real numbers and what they mean
- Next you see their EBITDA adjustments, in this case for interest and depreciation. The justification for adding them back in to determine value is that the buyer (in this case) would not be paying that same interest when they own the company, and depreciation is a non-cash expense.
- For more details specifically about add-backs, read our article here [link to add back article]
- Following that are the miscellaneous adjustments.
- In the first sub-section they are actually reducing the value in the top line with the rent/mortgage adjustment, which you don’t see very often initially (they often leave it up to you to find these types of advantages). The reason for this is that there was no rent on the expenses, but since the buyer would not be acquiring the building in this transaction, it was only fair to show true financials including an estimated amount to rent or buy a building.
- In the next sub-section they are adding back a keyman life insurance policy. The idea is that this policy is tied to the current owner and not transferring to the buyer
- Again, for more details about who add-backs work, check out our article here [link to add back article]
- The next section is the often controversial “owner’s salary”.
- In this instance, however, I feel that the broker handled this very fairly, but it’s worth pointing out that this isn’t always the case (again, more info about that in the add-back article). What this seller had was 3 owners, each drawing a $1,000 salary, but only one of them worked full time, one part time, and one not at all.
- They added all 3 of them back into the financials in this section, however what ou see in the next section below that is where the broker/seller actually reversed $75,000 of it, with the justification being that the new owner should be able to replace the previous owner or hire someone to replace the previous owner for $75,000. You will see that adjustment listed under “Cash available to new owner, wage add-back”
- Note, a lot of seller/brokers want to add-back the entire owner’s salary, which I personally disagree with, and it’s often a point of contention and negotiation.
- This takes you down to the final adjusted cash flow of $124,457. I will be using this number, along with previous years adjusted cash flow figures in determining and discussing value.
Value of this Business
To determine the value that I would put on this business, I will first start with calculating the average of the 3 years adjusted cash flow that we have access to. Sometimes we will use 5 years if the business is larger or trending significantly in one direction or another.
Average Cash Flow = $119,281
As we’ve discussed previously, I start with what I want my minimum Return On Investment (ROI) to be, which is 20%. So if I were to pay 100% cash for this business (which I wouldn’t be…but this is how I determine value), I would want to earn 20% return on that cash investment.
The calculation then is simple: Take the average cash flow of $119,281 and divide by 0.2.
$119,281 / 0.2 = $596,405.
So if I paid $596,405 for this business and earned $119,281 per year back on that, I would achieve my 20% ROI. This makes $596,405 the maximum that I would consider paying for this business.
Now, that being said, in my opinion that price would be too high for a business this size, and it’s highly likely that the listing price would be quite a bit less than that. I would expect a business of this size to sell for a “3 multiple”, which means it would sell for 3x it’s yearly cash flow.
So in that scenario, this business would likely list for around $357,000, which is a price I personally would feel a lot more comfortable with. That would give you a very nice 33% ROI using the same formula that I outlined above.
Again, this business will be worth more or less to different people for different reasons, but using the numbers above, a safe value range would be between $350,000 and $596,000, and anything less than that could be considered a steal.
See you there.
Institute for Business Acquisitions