How to Value a Business

If you are fortunate to have found what you believe to be the right business to buy, the question then arises – what’s a fair price?  Unlike buying a home, there’s no multiple listing service with comparables to look at.  If you are like most buyers, you have never bought a business before and have no past experience to use as a guide. 

 Before we look at some valuation models, I’ll share a secret.  Buyers and sellers of small businesses often don’t really know what they are worth.  They tend to come at the question backwards.  The seller knows how much money is needed to move on and do something else, whether it’s retirement or pursuing a new career.  The buyer knows how much cash is available to invest and, after meeting with a banker, how much they can afford to pay.

 That may happen all too often in the real world, but let’s see if we can understand how to actually determine what a business is worth.  As you might suspect, there are several approaches.  One approach is to simply add up the value of all of the assets of the business.  For some assets, such as accounts receivable, inventory and equipment, that works pretty well.  The problem with this approach is valuing goodwill.

 Goodwill is the value of the business as a going concern in excess of the value of its tangible assets.  Think about it.  The business has a name, reputation, employees, customers and a host of other intangibles that create value.  It is obvious these intangible assets create value. However, these assets are difficult, if not impossible, to value.

 An economics professor would argue that the value of a business is the present value of the future cash flow that the business will generate.  This approach may be theoretically correct, but has little application in the real world. 

 The method that is most commonly used is to value the business based on a multiple of earnings.  To begin, we need to determine an appropriate multiple.   This depends on what rate of return you want on your investment.  The multiple is equal to 1 divided by the rate of return.  For example, a 20% return means you need a 5 multiple and a 25% return requires a 4 multiple.  Many small businesses end up selling in the range of 4-5 times earnings.

 The next step is to determine what earnings we use in our calculation.  Most advisors use what they call EBITDA - earnings before interest, taxes, depreciation and amortization.  This is actually an estimate of the cash flow the business generates after paying all operating costs, including reasonable compensation to the owner for services provided to the business.

 Calculating EBITDA can be tricky. One reason is that for tax purposes, business owners have a habit of running all kinds of questionable expenses thru the business.  There may also be expenses (such as what the owner is paid as compensation) that need to be restated to reflect fair market value.  And earnings often fluctuate significantly from year to year.  This makes projecting future earnings difficult and, as you might expect, a matter often debated between the buyer and seller.

 Another valuation method is to look at the sales price of comparable businesses.  As an example, plumbing businesses may on average sell for 60% of revenues.  This is a very compelling approach since it is based on actual deals.  The key is to find good data and understand what the numbers mean.  There are only a few services that track this information and you need to know what assets were included in the sale. 

 Let’s assume the buyer and seller ultimately agree on the method to use in valuing the business.  Unfortunately, they may not agree on what assets and what debt, if any, are included in the deal.  Theoretically, the valuation represents all of the operating assets used in the business (although cash and accounts receivable are typically excluded) with no debt.  In other words, you need to increase the price if accounts receivable are included in the sale and decrease the price if any debt (such as accounts payable) is assumed by the buyer. 

 If you have managed to follow this discussion on valuation, congratulations!  This is a difficult topic, even for professionals.  As you can see, each method has its own advantages and disadvantages and you will ultimately end up with a range of values. Hopefully, you can negotiate a price somewhere in that range.   But what if you and the seller can’t agree?  We’ll talk about using an “earn-out” to bridge the gap in our next post.