HOW MUCH IS MY BUSINESS WORTH?
The author (Gary Schine)
How much is my business worth?
A Guest article by Gary Schine
We hear these questions a lot from business owners. Sometimes it’s because they want to sell their business or take on a partner, or do some estate planning. More often, it’s because they’re just curious; it’s just nice to know how much something you own might be worth.
There are all kinds of rules of thumb out there as to how the value of a business is established, such as:
- a company is worth a multiple of 4 times (or some other multiple of) its annual earnings. or
- a business is worth three times its projected gross profit for the next 18 months, or
- a business is worth 95% (or 125%, or 80% or any other %) of it’s annual sales.
The problem with these and any rule-of-thumb principles is either they are baseless myths or they are computed from averages of many business sales. It is a recipe for gross inaccuracy to apply such averages to any single business. For example, say you live in a neighborhood with the zip code 02905. You discover that the average family income in your zip code is $73,000. You also learn that the average income in the neighborhood right next door (zip 02906) is $87,000. So, you reason: “I think I’ll move a block over to that adjoining neighborhood and my income will go up by $14,000. Unfortunately, it’s not that simple.
Return on Investment (ROI)
There are several different methods used to determine the value of a company. However, when all is said and done, business valuation is based on perceived return on investment (ROI). A business buyer (like any investor), is making an investment and looking for a return on that investment. As with any investor, a business buyer has to figure in the degree he or she is taking on with an investment. The higher the risk, the higher ROI an investor will insist upon in making a deal. Small privately held companies are inherently risky, or at least perceived as such.
With few exceptions, an investor’s estimate of ROI is based upon projections as to what the future is likely to bring. Past performance is one indication of a business’ ROI, and therefore its value, but there are other factors that cannot be revealed through a company’s financial history. For example:
- potential for growth
- industry characteristics
- amount and quality of competition
- longevity and loyalty of customer base
- the overall economy
Negligible risk investments like savings accounts nowadays pay two percent at best. Government and blue chip corporate bonds pay a bit more. Stock in public companies can earn even more, however the risk of earning nothing and even losing money is very much there. Buyers of small businesses are aware of the risk they are taking and demand a high return on their investment. Typically businesses sell for return on investment in the range of 18% to as much as 50% or more. Or, stated another way, small businesses sell for multiples of 2 to 6 times annual earnings. For example 3 times earnings means an investor is demanding that he or she gets a return of 33.3% on the investment per year; if all goes according to plan the investor will get all his or her money back in 3 years. Two times earnings equals a 50% ROI, 4 times earnings equals a 25% ROI, etc..
It gets more complicated: Even a small privately held company’s current income and profitability is no simple matter. If a business’ accountant is doing his or her job, the tax return would often show as low of a profit as is legally possible. However, the profit of many small companies understate the benefits received by the owners. One of the jobs of a business valuation expert is to, in essence undo that accountant’s work and compute that full value and benefit the business is generating for its owners.
All revenues flowing to the owner are considered for business valuation purposes. This includes salary above the going rate, profit, and ALL benefits. There are terms used to explain this concept such as “excess earning” and “seller’s discretionary cash flow”.
It’s easy to throw out a number and say that’s what a business is worth. But, that number isn’t much to go on unless it is accompanied by an explanation as to how financial statements were recast, how the expected rate of return an investor would expect is calculated (the multiple and the reasoning behind it), and what assets are and are not included in the sale.
Gary Schine is owner of Merfeld & Schine, Inc. a business brokering company. He is also part owner of www.freevaluationsonline.com. a business valuation website. The site offers a free business valuation based on the user answering about 20 questions (financial and non-financial) about his or her business. It also offers a full 9 page valuation report that fully details the reasoning behind the valuation amount, for $20.
Category: Personal Finance