Valuing A Business
By: Richard Parker: President of The Business For Sale Buyer Resource Center and author of How To Buy A Good AUSTRALIAN Business At A Great Price ©
There is probably no part of the buying process that worries a potential buyer more than overpaying for a business. While this is understandable (who wants to pay more than something is worth), it has more to do with misinformation and one's total approach to buying a business than it does to being an expert at appraisals. The truth is, value is completely subjective. After all, what one business may be worth to you is entirely different from what it is worth to the next person. While there are cases where people may not negotiate the best price possible for a good business you must know that no price is cheap enough if you buy the wrong business. In time, a good business will always justify the purchase price whereas a bad one may not ever allow you to recover financially.
What is Value?
In a nutshell, value must be measured by what you are getting in return for your money. You have to equate the purchase price against the benefits you will derive over the term in which you can realistically expect to own the business. As an example, you cannot simply measure the purchase price against the income that you will derive from a specific business. What about the daily enjoyments you will get from being your own boss? Or, the sense of accomplishment you will feel from building something? Maybe, it's the gratification that you will get from contributing to the lives of others (i.e. employees). Perhaps it will come from knowing that from the toils of your labor you have been able to provide certain things for your family that you could never even consider if you were working for somebody else. A good business will provide abundant rewards for you so in order for you to truly measure a business' value you have to consider all of the benefits that you stand to gain. Also, you must factor in what you could never have achieved if you don't go into business for yourself.
Think of it this way: the average person takes 30 years to payoff a mortgage and 5 plus years to pay off a car. Neither one of these will pay you a salary. While they both have their benefits, neither one comes close to what you can derive from a good business as far as overall benefits are concerned. Even with a home where you will build equity won't a good business do the same thing? Therefore, why shouldn't you take 3-5 years or longer to payoff a good business?
Traditional Valuation Methods
There are two main valuation methods which are far too complex to fully explain in a short article. These are Asset Based Valuations and Cash Flow Multiples. In the former, a value is attached to all of the assets of a business (machinery, equipment, etc.) and you purchase the assets accordingly. Generally, small business purchases do not use Asset Based Valuation Methods to establish the purchase price. For Cash Flow Based Multiples, a formula is used that combines the company's profits, owner benefits, adds back certain expenses and then applies a multiplying factor to this number to establish a purchase price. This is the method that is most commonly used and a general understanding of accounting principles is required to make this calculation. The multiples that are used are generally based upon what other like businesses have sold for but as a very general rule it is usually one to three times the cash flow.
Why These Methods Don't Work?
Despite their ongoing use, traditional valuation methods are so subjective that it is impossible to endorse them as foolproof. For example, there is no way that you can use other like businesses as a realistic barometer because no two businesses are the same. Furthermore, the financials being used are historical date and since the past is over and done with how can you accurately use the past to predict the future? Insofar as Assets are concerned, unless you fully validate the usefulness of the Assets this too becomes subjective. Notwithstanding the inaccuracies of these methods, you should use a factor of each to value a business from every angle possible and then balance it all with what the value of the business is to you.
No Two Businesses Are Alike
Although traditional valuation methods will use other like businesses for comparative purposes do not allow yourself to be lulled into believing that any two businesses are really alike. You may want to explore these situations to see what businesses may have sold for, but you are guaranteed that there are always enough differences to render these comparisons inaccurate. The only time where you can pay attention to a similar business is when investigating a franchise. Even in these situations there will always be an abundant amount of differences such as location, owners, marketing strategies, etc., however the business model itself is supposed to be exact so there is some credibility to making comparisons. You may want to have your broker pull the details on others businesses in the same field to see what the Asking Price was, earnings, down payment percentage and expenses, but other than that,t remember that just like human beings, every business is unique.
Good versus Cheap
If your intentions are to find a cheap business you must be prepared to never find one or to deal with one that may never turn into what you had hoped that it would. It's akin to buying a cheap used car versus a good used car that you have checked over extensively. Yes, there is a chance that you will get lucky and get one that runs relatively trouble free for as long time, but the odds are that you will get one that requires ongoing maintenance. Now, this may be fine for your basic transportation needs but if you need a vehicle to work as a sales rep on the road where down time means lost revenue then you would want a vehicle that is highly reliable wouldn't you? The same applies for a business; there is far too much at stake to buy something just because it's cheap or affordable. Unless you are a business mechanic you will probably spend so much time fixing it that you won't have time to run it. If you want to dramatically improve your chances for business success then look for a good business that can become great.
How Long Do You Intend On Working?
If you are 55 years old and only want to work for another 5-10 years, your value will be dramatically different for a certain business than an individual who is 15 years younger. You have to consider your overall health, energy level and the payout period on the business relative to the amount of years that you realistically can and will be willing to work.
This article represents a fraction of what you’ll learn on this topic in How To Buy A Good AUSTRALIAN Business At A Great Price© - the most widely used reference resource and strategy guide for anyone thinking about buying a business. Read a detailed listing of what you'll learn .