Valuing a business is more of an art than a science. Each industry tends to be unique, but there are a number of common valuation methodologies that are used and sometimes weighed against one another.
For example, when I sold my trade book publishing company a number of years ago, a common valuation approach in the industry was simply one times sales. But my profit margin was at least double, if not triple, the industry average—even in comparison to the largest publishers. Of course, I was determined to get a much higher valuation for my business . . . and the business deserved it!
The company that eventually bought it, I believe, primarily valued that business on the basis of EBITDA (earnings before interest, taxes, depreciation, and amortization), and valued the business at eight times, which was toward the high end of some recent deals, but my company offered significant growth and my products had strong long-term sales potential. However, I believe the buyer likely also focused on the fact that their eight times EBITDA price was exactly two times sales, and this valuation method gave the buyer a second “reality check” and likely helped produce a price ceiling.
Evaluate Your Risk
Although there are many valuation approaches, at the end of the day, you want to proceed only if you feel that the cash you will receive over time and the future value of the business will justify the risk—and in any business there is risk; you are not buying a U.S. Treasury Bill! Furthermore, while the price of a business you are evaluating may be perfectly reasonable, you need to look carefully at the alternatives—are there similar businesses that might be for sale?
Often, an owner of a business who hasn’t even considered selling it will jump on a firm cash offer. So ascertain the value of a business carefully before buying it, negotiate the best deal you can, but also find some alternatives so that you will have choices.
Beyond the financial statement you need to think: What am I actually paying money for? Is it the customers? The business model? The products? Are these all things that I really want to be paying money for?
Then you need to figure out what the “true” or “adjusted” earnings of a business are. If you are negotiating through a business broker or an investment banker, they may have already taken out expenses that you might not incur in running the business, and that should legitimately be added back to profits. For example, maybe the owner is paying himself a salary twice as high as a similarly talented manager could be hired for. Or maybe the owner’s private plane or Mercedes is not necessary for operations. On the other hand, most investment banks can be “too good” or “too aggressive” at adjusting earnings, and you will probably end up adding some expenses back if you are buying a business represented by an investment bank or from a business broker.
On the other side of the coin, the financial statements may be understating certain costs of the business. Maybe the owner’s daughter won’t want to work on Saturdays for minimum wage after the business is sold to you. Or maybe you will have to relocate the business to a more expensive facility.
Whatever valuation method you use, you don’t want to take financials, be it an income statement or a balance sheet, at face value—you want to adjust it to reality.