Wednesday, August 20, 2008

A Quick Way to Value a Small Business

Recently, I attended presentations on financing a business (by a banker) and buying a business (by a broker). In both, the speakers shared that a business was worth about 2 to 3 times cash flow. In the first case, banks would only loan money based on 2 to 3 times cash flow. In the second case, a business broker would typically price a business at 2 to 3 times cash flow.

For reference, cash flow is defined as the total of profit, depreciation, amortization, interest and owner's draw. All this information is easily obtainable from the owner's tax return, and it is common practice to request copies of the most recent three year's of returns during the due diligence phase. In financial terms, cash flow is related to EBITDA (earnings before interest, taxes, depreciation and amortization), which also adds back taxes paid.

Interesting, the broker shared that most small business owners will claim that tax returns don't represent the true earnings potential of their business. A common reason is that the current owner may have optional expenses, such as travel to conferences, higher end business vehicles or hiring of family members, that don't have to be incurred by a new business owner. While the reason may be accurate, banks will still only accept the financial information on a tax return for determining loan amounts.

While the valuation of a business seems to be complicated, I now have a good point from which to consider whether the price is reasonable or not. I can now do a quick analysis and confirmation of the market value of business and know whether a seller is listing too high. In addition, I know to watch out for statements such as "can have higher sales with right owner," which may mean the price is based on potential and not current cash flow. On the other hand, by comparing the cash flow to similar businesses, I can determine if the current business is underperforming and has more potential with a knowledgeable owner.

For more on The Practice of Personal Finance, check back every Wednesday for a new segment.

This is not financial advice. Please consult a professional advisor.

Copyright © 2008 Achievement Catalyst, LLC

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