Business valuation is both an art and a science. It is trying to understand what is being offered and what a potential Buyer will accept. The valuation must bridge the gap between the Seller's view of a business which is non-replaceable and the Buyer's quest to determine the true worth of the business and whether it will provide an acceptable profit for their investment. Both views are valid and should be addressed. Our goal is to satisfy both parties' concerns through our valuation of the business. We believe the neutral approach is the fairest and most objective approach.
We at Arizona Business Sales use a variety of methods when valuing a profitable business for sale. Many times it is not uncommon for us to use a number of methods and then take a weighted average. Some of the factors we consider when choosing methods are the size of the company, length of time in business, type of business, cash flow, amount of assets, competition, growth potential, attractiveness, key employees, condition of equipment, size and condition of inventory, long term outlook for industry and other unique factors.
Capitalized Earnings Approach: Normally the buyer is looking for a return on his investment and will not be active in the operation of the business. The higher the risk the business presents the higher the capitalization rate he will want. The condition of the business and length of time in operation are important in projecting future cash flow. Of course if the new owner plans to work in the business he must separate his fair market salary from the return on investment computations.
Excess Earnings Method: This method is very similar to the capitalization method except it splits of the earnings from assets from other profits. Because assets are only valuable if they are generating income you place a fair expected return on them. The remaining cash flow is derived from the quality of the operation. That remaining cash flow is the number used to place a price for the business after factoring in the industry, competitiveness, attractiveness, growth potential, risk and other factors.
Cash Flow Method: Many buyers are only interested in the cash flow the business generates. They are normally hands on operators who are replacing their work income by owning a business. The main concern is can the purchase price allow for debt service and still provide the income that they require. To make this happen the buyer will either qualify for an SBA loan and the seller will need to have the books and records for at least 3 years and show all the profits or if that is not possible they may need to carry some money in a note.
Rule of Thumb: Financial analysts do not like this method and we don't either. I use to use the analogy that if one foot was in a bucket boiling water and the other in ice water on average you would be room temperature. Each business is unique. The rule of thumb averages may be accurate if everything about the business such as profits and expenses match the industry average the sale price might be correct. But to apply it where significant differences exist is not appropriate.
Discounted Cash Flow: a complex method we use when dealing with a large well established business. We take the up and down cash flows of the past years to predict future earnings factoring in specific business trends. We then discount that cash flow by an acceptable rate for the investor allowing for risk and time. This method is difficult to do but is the most accurate way to price a business. There is much more to it then stated here, this is only an overview.
Tangible Assets: In some instances a business is worth no more than the value of its tangible assets. Normally the business is not profitable or making is making income for the owner that is below market value. Selling is often getting the best possible price for the equipment, inventory and other assets of the business. There are times when buyers will also purchase leasehold improvements. In place value can be higher then if the items are sold piece by piece. It can be priced compared to the cost of starting new.
We choose the method most closely suited to the business at hand, although many times we will look at two, three and sometimes four to make sure we are reflecting the business in its most accurate light. There are variations to all these methods and the ones used depend on the business itself. The goal is to find the fairest price for the seller and one where the buyer sees the worth.
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