Valuing a Business

You have worked for a business for many years and the owners decide to leave the business or leave the area and you have a chance to buy the business for a song. You need to show the lender or investor what the business is really worth, unless you can pay Cash! If you can pay cash, you don’t need to read the rest of this article.

Valuing a Business is part science and part art. There are more ways to value a business than Carter has Pills! Sorry, Old Analogy, but there are many ways to value a business depending on what kind of business and what are the sales and profits generated by the business. 

There are essentially three Good Avenues to follow to value a business and they are discussed below:

1) The Value of the Business Assets. What does the Business Own? You need to add these Assets      together to arrive at a Final Value of the Business.

What is the Dollar Value of the Real Estate?

What is the Dollar Value of the Equipment?

What is the Dollar Value of the Furniture and Fixtures?

What is the Dollar Value of the Inventory?

What is the Dollar Value of the Intellectual Property (Trademarks and Patents)?

What is the Dollar Value of the Employees?

– and any other Asset the Company Owns that you think has Value.

2) Value of a Stream of Cash. What are the Revenues and Profits worth to you?

Investor Real Estate will usually use the Capitalization Method. This method is a Projected Rate of Return if the Buyer Pays all Cash. The Cap Rate is determined by taking the Net Operating Income of the Property and dividing it by the Cost of the Property which Equals the Rate of Return. The Rate of Return should be equal to the Return other Investors are receiving in the Market Place. This Cap Rate could also be compared to the Rate of Long Term Treasury Notes plus a Risk Factor. Long Term Treasury Notes are usually 10 year Government Notes with no Risk. You need to Add a Risk Factor to the Treasury Notes to Equal a Normal Rate for an Average Investment. You can also get the Cap Rate by Asking a Commercial Real Estate Realtor.

Service, Retail, Manufacturing, or Wholesale Business will use methods other than the Capitalization Rate. You want to Asses the Value of a Steam of Cash either by using Sales or Earnings/Profit numbers. Most Industries have a Multiplier of Sales or Earnings that the Business is worth or that most business of that type could be bought. An Example is the Hair Salon business. An article in Forbes Magazine by Tom Taull on 7-15-09 referred to another article by Tom West, The Business Reference Guide. This article gave a method of valuing a Hair Salon by using a Multiple of Earnings plus Inventory and another method of using a Percentage of Sales plus Inventory to Value a Hair Salon Business.

Usually there are method for using Sales and Earnings Multiples or Percentages to Value many businesses in many different Industries. The trick is to find out this method for that particular industry that business is using in that industry. 

3) Discounted Cash Flow Methods which include Net Present Value (NPV) of an Income Stream and the Internal Rate of Return (IRR) of an Income Stream. The following Definitions and Uses are taken Directly from Wikipedia, the online Encyclopedia.

Net Present Value (NPV) – “NPV is an indicator of how much value an investment or project adds to the firm.” Can be used to state the value to a firm of single or competing projects that have a series of Cash Flows over a period of time.

Internal Rate of Return (IRR) – IRR”is a rate of return used in capital budgeting to measure and compare the profitability of investments”.How to use the IRR, it”must be greater than an established minimum acceptable rate of return or cost of capital.”

Example: the following example was calculated on a HP 12C financial Calculator.

Owners of a Hair Salon were selling the business to a long term employee who was the manager for the last Six (6) years. The purchase price was $50,000 and the borrower had 20% to put down on the purchase and had talked to a bank about financing the remaining 80% or $40,000. The bank was using the SBA 7a program to finance the deal and needed to provide the SBA with a Business Valuation.

The Consultant working for the bank to organize the SBA 7a Package needed to Perform a Business Valuation of the Business. The Consultant used the following three methods to place a Value on the Business:

1) The Value of the Business

     The Furniture and Equipment were worth approximately $32,655

     The Inventory was worth approximately                         $53,457

     Total Value of the Assets of the Business                       $86,112

2) Value of a stream of Cash – What are the Sales and Profits worth to you?

     This formula was taken from the Forbes Article written by Tom Taull on 7-15-2009, and 

     Mr. Taull quoted The formulas of Tom West who wrote, “The Business Reference Guide”.

a) Valued as a Multiple of 2 to 3 Times Pretax Income Plus Inventory – the Hair Salon had a   &nb
sp; Pretax Income of $30,000, and an Inventory of $53,000.

    $30,000 x 2 = $60,000 + $53.000 =  $113,000

    $30,000 x 3 = $90,000 + $53,000 =  $143,000

b) Valued as a 25% to 35%, Percentage of Total Revenue plus Inventory – the Hair Salon     has a Total Revenue of $580,000, and Inventory of $53,000.

    25% x $580,000 = $145,000 + $53,000 = $198,000

    35% x $580,000 = $203,000 + $53,000 = $256,000

Average of these two methods is $177,500

3) The Discounted Cash Flow Analysis Valuing a Project Using the Time Value of Money as a

    Guide. The methods we will use are the Net Present Value (NPV) and the Internal Rate

    of Return (IRR). We will use the Wikipedia definition and use for both of these methods.

a) The Net Present Value (NPV) – the “NPV is an indicator of how much value an investment     or project adds to the firm”.

    NPV = $181,652

b) The Internal Rate of Return (IRR) – the IRR “is a rate of return used in capital budgeting to     measure and compare the profitability of investments”. How it is used, the rate “must be     greater than an established minimum acceptable rate of return or cost of capital.

    IRR = 59.40%

Summary: The value of the Hair Salon is much greater than the $50,000 that the buyer paid for the Business. This is the exact reason that you want to perform a Business Valuation. We valued the Business at $180,000. Using the following methods to guide us:

Value of the Assets =         $  86,112

Value of the Average of Income and Sales Methods =  $177,500

Value of the Net Present Value =  $181,652

Value of IRR = 59.40% this is a very high rate of return and confirms that the price is undervalued.

Please address any questions or comments to roger@rogerschlueter.com or visit my website at www.schlueterfinancial.com for additional contact information and additional financial information.