Valuing a Business
While these series of articles are dedicated to matters concerning commercial real estate, when a business sale or purchase is contemplated, a valuation of the business must be considered either in conjunction with, if not prior to, assessing real estate needs. How do I go about arriving at that might be the first question that arises.
There are numerous and often interrelated methods that may be used, from the very simple to the very complex. For the sake of brevity, let’s consider just a few of the basic methods here as a start:
Balance sheet or substitution approach
Quite simply, the sum of all assets less liabilities. This method may be particularly applicable to businesses where fixed asset or inventory costs are relatively high in relation to sales as it emphasizes a value of at least what it would cost to form the business anew, or its value if liquidated. However, it may not reflect the value of intangible non-balance sheet items such as the business’ reputation or proprietary production methods for example. Further, it neglects the business’ future earnings potential, and for that reason, its use as a stand-alone method may be appropriate for a business with markedly declining sales, but should be used in conjunction with the following approaches for a thriving business.
Since a business buyer is essentially acquiring an income stream, this approach assigns a present value to that future income through a rate consisting of the expected return and the risk of actually receiving the income on a timely basis. Begin by assessing net income (before taxes, non-cash expenses such as depreciation, owner’s compensation and/or personal expenses charged to the business), less non-recurring earnings, as well as year-to-year trends in those numbers. Valuation may then be derived through dividing annual net income based on historical earnings by the desired capitalization rate, or through projected future earnings discounted to present value. Either will yield the same result where sales are expected to be relatively stable, while the latter may be preferential where accelerating sales are anticipated.
This valuation method may also be calculated and expressed through an income multiplier. For example, a 20% capitalization rate is equal to an annual income multiplier of 5. Such multipliers are not limited to, but may commonly range from 2-10 dependent upon the industry and the level of risk. A well-established business, with good growth potential, whose future earnings will not be dependent upon current management will likely lie in the upper tiers. Conversely, a business lacking competitive advantages, operating in a stagnant market, with limited assets, or a reliance on current management to ensure current revenue stream will likely lie in the lower tiers.
A multiplier based on gross sales may be used in cases where input costs may change post-sale, and thus prior net income figures may be irrelevant to future net income (i.e. manufacturing is to be integrated into a current production facility, or a new business where start-up costs presently exceed revenue). Like income multipliers, these may also vary depending on industry and also anticipated profit margins, and while not limited to, may commonly range from slightly over zero to 3.
These methods are certainly not all-encompassing. Other factors such receivable aging, liquidity ratios, cash flow, and industry trends may need to be evaluated. Likewise, peer analysis will be essential in determining comparative benchmarks for sales and income expectations. Additionally, a combination of these methods may be employed to determine a weighted measure of value where the business’ strengths or weaknesses lie in different areas.
If you’re pondering either a business sale or purchase, this is intended simply as ”food for thought,” but if after more extensive evaluation you’re decided you’re ready to proceed, we’re here to assist with your real estate needs in the next step of the process.