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  Thailand Articles

15 Feb 2008 20:31:10 GMT
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Calculating the Value of a Business

Accurately valuing a small business is often the most challenging part of the process for prospective business buyers. However, it doesn’t have to be an overwhelming or difficult undertaking. Just remember that valuation is an art, not a science.

Naturally, a buyer’s valuation is usually quite different from what the seller believes their business is worth.  Buyers want to buy the business for as little as possible. Sellers usually factor their years of hard work into their calculation. And, undoubtedly there were many years of hard work and worries. However, that’s not how you determine the value of the business.

The challenge for is to calculate a value that is accurate, and that will provide the buyer with an acceptable return on investment.

There are several ways to calculate the value of a business:

  • Asset Valuations: Calculates the value of all of the assets of a business and arrives at the appropriate price.

  • Liquidation Value: Determines the value of the company’s assets if it were forced to sell all of them in a short period of time.

  • Income Capitalization:  Future income is calculated based on historical data and a variety of assumptions.

  • Income Multiple: The net income of a business is subject to a certain multiple to arrive at a selling price.

  • Rules Of Thumb: The selling price of other “like” businesses is used. 

Asset-based valuations do not generally work for small business purchases. Assets are used to generate revenue and nothing more. If a business is "asset rich" but doesn't make much money, how valuable is the business itself? Conversely, if a business has limited assets, such as computers and office equipment, but makes a ton of money, isn't it worth more than the resale value of those computers?

Income Capitalization is generally applicable to large businesses and most often uses a factor that is far too arbitrary.

The “Rule of Thumb” method is too general. It's hard to find any two businesses that are exactly the same. Valuation must be done based on what the buyer can reasonably expect to generate in revenues, so long as the business’ future is representative of the past historical financial data.

The Multiple Method is the way to go for small businesses. You have probably heard of businesses selling at “x times earnings”. This can still be quite subjective, because earnings can actually mean different things in different businesses. When buying a small business, every buyer wants to know how much money he or she can expect to make from the business. Therefore, the most effective number to use as the basis of your calculation is what is known as the total Owner Benefits.

The Owner Benefits amount is the total dollars that you can expect to extract or have available from the business based upon what the business has generated in the past. Owner Benefit is not cash flow!

The theory behind the Owner Benefit number is to take the business’ profits plus the owner’s salary and benefits and then to add back the non-cash expenses. This is the most effective way to establish the valuation basis of a small business. Then, a multiple, based on a variety of factors, is applied to this number and a valuation is established.

The Owner Benefit formula to use is:

   Pre-Tax Profit

+ Owner’s Salary

+ Additional Owner Perks

+ Interest

+ Depreciation

- Allowance for Capital Expenditures

 

Why Add Back Depreciation?

Depreciation is an expense that allows a business to deduct a certain amount of money each year from an asset so that its purchase value is reduced by its overall useful life. As an example: if the business buys a ?25,000 truck and its useful life is estimated at 5 years, then each year the company can deduct ?5000 off its income to lessen its tax burden. It is not an actual cash transaction. No money is physically leaving the business or changing hands. Therefore, this amount is added back.

 

Why Add Back Interest?

Each business owner will have his/her own philosophy for or against borrowing for the business. In most cases, the seller will pay off the business’ outstanding loans from their proceeds at selling; therefore, you will have the use of these additional funds.

 

A Note About Add-Backs

After completing any add-backs, you’ll want to take into consideration the future capital requirements of the business as well as debt-service expenses. As such, in businesses where equipment needs replacing on a regular basis, you should deduct appropriate amounts from the Owner Benefit number in order to determine both the true value of the business, as well as its ability to fund future expenditures. Under this formula, you will arrive at a "net" Owner Benefit number.

 

What Multiple?

Typically, small businesses will sell in a 1-x to 3-x multiple of this “net” figure. Now, 1-3 is a wide range, so how do you determine what to apply? The best mechanism seems to be that a 1-x multiple is for those businesses where the seller is “the business”. Consulting businesses, professional practices, and one-person businesses are examples of this kind of business.

Businesses that have a strong track record, repeat clients, historical pattern of growth, more than 3 years in business, perhaps some proprietary item, or an exclusive territory, a growing industry, etc., will sell in the 3-x ratio. The others fall somewhere in-between.

So now the big question: what number/multiple do you apply to the Owner’s Benefit number?

How much ROI should you expect?

You also want to calculate the Return-on-Investment (ROI) that you can expect to achieve when buying a business. Let’s say that you have ?100,000 for a down payment. If you go to one of the new Macau casinos and let it rip on “17 black” on the craps table, you should be entitled to enormous odds. On the other hand, if you invest it in commercial real estate, which is a solid, stable investment, then 10% return on your money might seem about right. 

Buying a business is clearly riskier than real estate but definitely not as risky as the Macau option, so you should expect something in-between. 25% return on your investment should be the starting.

 

Value is Personal

If the business is right for you, it is all right to pay a slight premium, but not to drastically overpay.

The Key Points
Remember that valuations are not science; they’re subjective.

  • Owner Benefits is the number on which to base your multiple.

  • Valuation is a personal formula - What’s the business worth to YOU?

  • Consider the potential return on your cash investment.

The Final Word: Never, ever buy a business just because the price is right - first and foremost be certain that the business itself is right for you!

 


 
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