Article by Roger Schlueter, MBA
There are many methods in the valuation of a business. The easiest method would be a Multiple of Sales or Earnings. The trouble with these easy methods of valuing a business is that they are based on a multiple that has nothing to do with that specific business except for the Sales or Income Level. These methods are usually used in industries where the Industry values their businesses that way. Both of these methods can be wrong for many reasons.
The Sales Multiplier – this form of valuation does not address if the company is making money or not. I’ve seen firms with huge sales but they were losing money at a rapid pace.
Income or Profit Multiplier – this form of valuation is probably better than a Sales Multiplier but it is based on who decides how high the multiplier will be. I can show you how to manipulate the earnings, so as, to get a higher or lower Net Income or Net Earnings. This manipulation is usually accomplished by manipulating the COGS (Cost of Goods Sold) or the Depreciation.
My three favorite ways to Value a Business are:
1) The Capitalization Approach
2) The Cash Flow Method
3) The Tangible Assets Method
These three methods for determining the Value of a Business can be better or worse depending upon the type of Business, the Cash Flow of the Business, and the Assets associated with the Business. I feel it is better to use all three methods and then to either pick one, average them, or assign a weighted average to them. I will give an example of each method and then we will try to analyze the different methods.
Method One – The Capitalized Earnings Approach
This method is based on the average earnings capitalized at the required rate of return on investment. The percent of the rate of return is also the number of years it will take the earnings to payoff in excess earnings.
Example – $50,000 earnings with a required rate of return on investment of 10%. This will be $50,000 / 0.10 = $500,000. Your Required Rate of Return could be the rate of return of a Government Bond plus the Risk Rate. An example of this would be a 10 year Government Bond paying 5% plus a Risk Rate of 5% added to create your Required Rate of Return. So the Purchase Price would be $500,000 to Purchase an Income Stream for 10 years of $50,000. There are many variations on this method.
Method Two – The Cash Flow Method
This method is used when trying to determine how big of a loan that the business can support. The Cash Flow is used as an indicator of the company’s ability to service the debt that will be required to purchase the company. Cash Flow is Net Income + Depreciation + Interest = Cash Flow of the Business.
Example – The Net Income is $50,000, the Depreciation is $10,000, and the Interest is $5,000. The Cash Flow is $65,000, the rate of interest is 10%, and the Term of the Loan will be 20 years. This is calculated as a Loan with an Interest Rate of 10%, a Term of 240 Payments (20 years), and a Monthly Payment $5,416 (Cash Flow of $65,000 divided by 12 = $5,416 Monthly Payment). This means that a borrower can borrow $561,232 and be able to Service the Debt.
Method Three – The Tangible Assets Method
This method is based on the Value of the Assets of the Company.
Example – The Real Estate is worth $500,000 and the Equipment is valued at $50,000. You would need to get the property appraised by a competent Real Estate Appraisor (Most Real Estate Appraisors use three methods of Real Esate Valuation, 1) Market Value, 2) Income approach, and 3) Constructing New).
Looking at our Three Methods of Valuation, we could come to the conclusion that the business is worth at least $500,000 or more, and could Support a Loan of up to $561,232. Just like Real Estate the Business is Really Worth the Amount that Someone is Willing to Pay and the Amount that Someone is Willing to Sell the Business For.
This article was written to give you ideas and possible methods of valuation but remember there are many other methods and many variations of all methods.
Please go to my Webpage at www.schlueterfinancial.com for Contact Information or other ideas.