Business Valuation Methods

So, here are the most popular business valuation methods in use today:

• Industry formulas.
  Certain business types have standardized formulas for determining market value, such as: $X per keg of beer sold in some classes of taverns; $X per unit sold during the year for certain types of vehicle dealerships; $X per average weekly sales; etc.

  Most industries (especially franchises) will give a potential buyer some guidelines for setting the value of a business using their own industry's formula. These guidelines are often more accurate than many of the so-called "standard" methods of determining the value of a business. But remember, they are still only guidelines.

• Industry Multiples.
  This is different from the above method in that it is more universal, and better understood than some of the other methods. A multiple is simply the pre-tax profit of the business multiplied by an industry multiple…usually from (1) to (10). Most CPAs can give you a good idea of the range of multiples for the business you want to buy.

  The multiple usually doesn't vary much across the country, but it can vary substantially across individual businesses.

  An optional approach to this method of valuing a business is to value the business as a percentage of the annual gross revenue. This method is especially popular when valuing franchises.

  The primary problem with this approach is the issue of profitability. Two businesses could have the same revenues and therefore similar values---but one business might have twice the profit of the other. This would require some serious adjustments to the original calculated value.

  The biggest problem with this method is that it is very broad brush, and fitting a particular business into the industry multiples method is usually not very accurate. It should be used just as one more guideline to give you a base from which to determine your own projected value for the business you want to buy.

• Book Value.
  This is one of the more universal business valuation methods, and is roughly the Assets minus the Liabilities. Actually, this is more of an accounting value than a true business value.

  However, it can always be considered as one more guide in determining the value of any business.

  Unless the business you are looking at is a micro business, I would not put much stock in this calculation (although banks tend to get excited about this number when you talk to them about a loan).

• Asset Valuation.
  Different people call this method by different names, but it is simply the value of the assets being sold plus some additional value for premiums (in most cases). This method becomes more important when you are buying assets rather than stock in the business.

  This can also be a very important method when assets are a major factor in the value of the business, such as manufacturing companies that have major investments in specialized machinery and equipment, or if you are buying a trucking company.

  The difficult part of this business valuation method is determining what the value is for the asset "premiums," such as; customer lists, patents, location, goodwill, talent, and the like.

• Discounted Cash Flow.
  This is a highly popular method of determining the value of a business, because it involves the future success of the business. This method can get a little tricky, so I suggest you work closely with your accountant in making the calculations.

  For obvious reasons, accountants favor this method because it usually takes a CPA to come up with a value. You still need to remember that even this technique only gives you a guide as to the value of the business.

• All Others.
  There are other business valuation methods as well , but when it comes right down to it, the value is whatever the buyer and seller agree it is. It often doesn't matter how you arrive at a value, just that both buyer and seller agree that it is fair.

Unless you are an experienced buyer of small businesses, I strongly encourage you to utilize professional advisors (your CPA and attorney) when going through the various business valuation methods.

But the final number you pick for starting your negotiations is still the one you feel most comfortable with. Remember, you are the buyer, and you need to buy at a price you can feel good about.

Now you have some idea of various business valuation methods you can use when you try to buy a business. There is no precise formula, but these guidelines will give some idea of where to begin your negotiations.

However, there is one caveat in determining the value of a business, and that is the mysterious means of valuing Inventory---if the business involves inventory. This is the single biggest bug-a-boo in buying a business that has inventory.

So, I recommend you read the next report in this module, titled, Small Business Inventory Management. It could save you a lot of money if you are buying a business with an inventory.