This article has been adapted from How To Buy A Good Business At A Great Price, a course written by Richard Parker at RichardParker.com. To gain access to the full course, which walks through the entire process of purchasing a business and breaks down these valuation methods in further detail, click here .
Let’s get one thing absolutely clear from the start. What a seller thinks their business is worth rarely has anything to do with its value.
Trying to put a value on a business in the traditional sense is a complex and difficult process. In this article, we will cover the guidelines and formulas that buyers and sellers traditionally use to establish the purchase price and deal terms. As you can imagine, there is a lot of room in between.
Remember that the asking price is only ever a starting point and is always negotiable. If you pay too much attention to it, you will investigate the business trying to reconcile how this figure was reached. Or you will spend too much time trying to disprove the rationale behind this figure. Since there are no objective standards, this is often an impossible task. The seller believes that the asking price is what the business is worth, but that’s only their belief.
Sellers – often under the guidance of business brokers or appraisers - can focus too much on how much similar businesses have sold for, or valuing certain assets. But focusing too much on yourself doesn’t take the most important factor into consideration – how much is the value to the buyer? Bear in mind that valuation is an art, not a science – and there is always an element of subjectivity involved.
Traditional Valuation Methods
There are two traditional methods that are used for valuing a business: asset-based valuation and cashflow-based valuation. We shall study the various techniques that are used for both, and provide you with an insight into what each offers and how they differ.
Asset-Based Valuations
In this method, the assets of a business that are used to produce income are given a value, and then totaled to establish the purchase price. While this sounds straightforward, it isn’t. The value of assets is rarely set in stone and is reliant upon there being an actual buyer of those assets in the first place. Even factoring in depreciation, some items are still often overvalued on balance sheets.
Fair Market Value
For definition, we shall consider FMV to be: ‘the realistic value at which assets can be sold on the open market’. Calculating this requires discounting the value of assets appropriately – this might be things such as Accounts Receivable when large amount of money are due into the business but uncollected. Or it could be inventory, which typically is given at 90% of its value for all products that are saleable to customers within the next 12 months. Office furniture and other equipment typically is worth about 15-25% of its retail price when used.
Liquidation Value (LV)
Liquidation Value (LV) is very different from FMV in that it determines how much you could get for the assets if you had to turn them into cash within 30-180 days. I think this method is unrealistic, personally – why would a seller go through the hassle of selling a business if the best price they can get is the Liquidation Value of its assets?
Cashflow-based valuation (CFB)
Cashflow-based valuation is the most popular method of valuation, although the term is often used incorrectly. In many cases it does not mean the cash flow of the business in accounting terms, but rather it is a formula by which the company’s profit (and certain adjusted expenses) is multiplied to establish a price.
Adjusted EBITDA Multiple Valuation
Of all the so-called ‘standard’ valuation methods, I favor the EBITDA Multiple method over all others, even though it has its downsides. EBITDA multiple valuation uses the most recent year’s financial statements to establish a profit figure, then multiplies that figure by a certain factor to arrive at the value of the business.
EBITDA assumes a debt free managed business. It finds the total Owner’s Benefit (sometimes referred to as ‘Cash Flow’ on listed businesses for sale or ‘Seller’s Discretionary Earnings’) by adding together: pre-tax income (sometimes referred to as ordinary or net income) + owner’s salary + owner perks + non-recurring expenses + interest + depreciation + adjustment for a manager + miscellaneous. To this figure is then applied the ‘multiple’ which will vary by industry and by location.
Here’s an interesting note about multiples. In Florida they did a review of several thousand businesses that had been sold through business brokers over many years. The average multiple: 1.97 times the total Owner Benefit amount. The purchase price amongst the same group averaged 87% of the asking price. The above data is provided more for conversation; do not use these as a barometer of what to do or expect. Every deal is different.
Discounted Cashflow
The concept behind this is to use projected future cashflow as the basis for determining value. Large corporations use this method mainly and there are many complicating factors that are considered. One thing that is used is the present value of money, sometimes referred to as the “Time Value of Money.” This term is used to explain the rationale that money in your pocket today is worth more than the same money in the future.
The Diomo Business Assessment Method™ (DBA)
Each of these traditional valuation methods has drawbacks, which is why I’ve formed my own valuation method over many years. It’s called the Diomo Business Assessment Method™, and it addresses all of the peculiarities of the business.
This includes customer relationships, reliance on the owner, potential pitfalls, a company’s strengths and weaknesses in all aspects, competition, barriers to entry, growth potential, threats, and many other factors. A score is attached to each of these factors which is used during valuation.
You can calculate the value of a business using the DBA valuation spreadsheet which is contained inside my full How to Buy a Good Business at a Great Price™ guide. In this article I will give you an idea of how it works.
You will need financials on the business you are valuing for a certain period. A business that is trending upward is worth more than a business in decline. That is why we cannot simply have an average of the past, and need to weight it appropriately:
- Most recent 12-month fiscal year: 70%
- Prior Year: 20%
- Year Before: 10%
After this, we take into consideration some important factors, such as debt service and recent trends. The score of the fundamentals gets factored into the weighted average of the profitability of the business, and a multiple is attached which leads us to our final valuation.
Now it’s time to compare this figure to the asking price your seller has given you, and begin the negotiation phase. There are many tactics you can use to drive these conversations in a direction that benefits you – but we’ll get into that in the next article.
