Valuing and Evaluating a Small Business

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There are a variety of ways in which a small business can be valued. Some experts use multiple of sales and/or multiple of cash flow. However if a business has predictable cash flow, the best approach to valuing this business is by determining the present value of future cash flows. To make a sound buying decision, one should not only look at price but also consider the qualitative aspects of the business.

For example, you are interested in buying a Laundromat. Say it has a cash flow of $100,000/year and will so for the next 10 years. The owners are asking $400,000. At the end of 10 years lets assume that you may be able to sell the store for the same amount of money you bought it for -- $400,000.

The first step in valuing a business is determining the discounted cash flows for the first ten years. Lets use a risk free rate of 10% again to be on the conservative side (the current rate on the 10-year bond which is the risk-free rate is around 4%).

The following table summarizes the discounted cash flow over ten years and the value of the business in present value terms.


1 90,909
2 82,645
3 75,131
4 68,301
5 62,092
6 56,447
7 51,316
8 46,651
9 42,410
10 38,554

Total Present value of Discounted Cash Flow at the end of 10 years
614456


Present value of sale price of 400,000 at the end of 10 years
154,127

Total Intrinsic Value
768,583

In other words if the owners are asking $400,000 then we can buy the business for a 48% discount off its intrinsic value. So depending on what kind of margin of safety we are looking at, we can decide whether the business price is palatable or not. We should look for a higher margin of safety or in other words a larger discount to intrinsic value if the business does not have a predictable cash flow year over year.

Lets talk about the qualitative areas that need to be analyzed before buying a business.

They have been categorized as:
(1) Company
(2) Competition
(3) Customers

Company
We would like to buy a company with strong history and therefore a company that has good brand recognition. We also want to make sure that the key employees are going to be around after the company changes ownership. This is critical in small companies as an early departure of key employees can cause the business to falter while the new owner is still in the learning stages. Another key area is the opportunity for growth. We should see if there are any products/services that could be offered in future that are extensions of the current offerings or is it possible to introduce new products that could be profitable for the company.

Competition
Ideally, we would like a company that as no or little competition. We need to determine if a company is selling a product or service that is a commodity (such as groceries) or is a niche player. If the company offers products/services that are commodities, probability is fairly high that the margins will be very low. To compensate for that, the business needs to have a very high volume. On the flip side, if the company offers service or product that is unique it can charge premium for that and so high volume may not be a requirement.

Customers
This is another important aspect of the business. There are several questions that need to be answered as far as the customers are concerned. They are:
Who are they?
Who are the largest customers and what percentage do they contribute to the revenues?
Are most of the customers long-term or does the mix change every year?
Why do customer come to this business versus the competitors (i.e. Is there a differentiating factor between this business and the competitors)?
How does the company acquire new customers?
What marketing programs are in place to retain current customers and attract new customers?
Ideally we would want a customer base that is steady but growing. Also, we would want that the largest customers individually not contribute to more than 5% of the revenue. In the event that we loose a customer, we take a 5% hit which can be absorbed without major impact.

Other Factors
If a buyer is venturing into a new industry, he/she should consider having training and consulting arrangement with the previous owner, a part of the purchase agreement. This can help smooth the transition of ownership. Also, if any unforeseen circumstances arise, the new owner can hire the seller as a consultant.

Another key factor is the accuracy of financial statements. In order to ascertain that, one should conduct a random audit of the financial statements from last few years.

Most owners are selling for the right reasons which include other interests, retirement, family situation, etc. However, the buyer should clarify the intent behind the sale. If the seller does not have a clear reason, that should raise a red flag for the prospective buyer.