Business Valuation  - Basic Principles

One of the most frequently asked question that I receive relates to the value of a business.  The simple answer is that a business is worth what ready, able, and willing buyers and sellers in open and fair market conditions would agree to on that particular business.

How do we determine value prior to taking a business to the market?   This is both a complex and subjective issue.  To begin with, there are few if any valid direct comparisons to draw from.   No two businesses exactly alike, even within the same sector or industry, and there are no public sources providing information on sale of businesses.

There are many “rules of Thumb” methods utilized in various industries to get an indication of value.   These can be helpful to a certain extent but tend to be of little value in assessing the specific issues surrounding a particular business.   A simple example of this might be two identical franchises each generating the same gross sales revenues.  A “Rule of Thumb” approach based on gross sales would suggest that both should be valued equally.  But what if one location was locked into a punitive long-term lease?  It is not likely that an astute buyer would then consider the two businesses of equal value.

What then determines the amount that a buyer might pay for a business?  In simple terms it is “Risk vs. Reward”…. how much am I investing, what is my potential future return  on that investment, and what is my risk?   To reasonably value a business we must truly put ourselves in the buyer’s shoes!

The price of a business is commonly defined by way of a “multiple” of earnings. (i.e.: 3 times earnings).  One must be careful to use the proper methodology when determining the earnings figure to be used  (i.e: typically a "Normalized" value based on "EBITDA" or "SDC").  The “multiple”  is a numerical value reflecting the various risk factors associated with the business and its perceived ability to sustain earnings into the future …. higher perceived risk yields lower multiples.  These multiples can typically range anywhere from 1 to 5 times earnings, depending on the perceived risk and the methodology used to calculate earnings.

In order to value any business we must take a comprehensive look at the specific aspects of the business.   We must attempt assess the factors that any prudent buyer might consider such as earnings, hard assets, human resources, desirability to a buyer, financing, operational complexities, and the strengths and opportunities of the business.   Clearly, many of these assessments are inherently subjective, and will vary from buyer to buyer.   In general however, as we look at each individual element as objectively as possible, a picture of the risk aspects of the business becomes apparent, and a range of price begins to emerge.

 

Patrick S. Preston, Agent

Business Brokerage Specialist