Soon after taking early retirement, I attended a seminar by a business broker. To me, the most interesting part of the presentation was his methodology for valuing a small business. Basically, he shared that a good price for buying a small business was two to three times cash flow. As I understand it, cash flow = profit + depreciation +amortization + loan interest + owner's compensation. (I believe owner's compensation is added back only for corporations).
Thus, if a business has $50,000 free cash flow, a good price would be $100,000 to $150,000. For a business with $200,000 free cash flow, a price from $400,000 to $600,000 would be a good price. I would expect to pay a higher price for a cash flow of high certainty and a lower price for a cash flow of lower certainty.
I came to the conclusion that a business valued at $100,000 to $150,000 would not be worth owning for us. $50,000 of free cash flow for working 40-60 hours a week as a owner would not be sufficient return. To me, I would be as well or better off finding a job that paid $40,000 a year, since it wouldn't require any upfront investment on my part.
On the other hand, I would consider a business that generated $150,000 of cash flow as worth the effort. However, at this time, I'm not ready to invest $300,000 to $450,000, which is the minimum needed to purchase such a business.
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4 comments:
I think the multiple that you use should depend on the industry you are looking into. Every industry is unique and to say 2-3 times CF for every type of business would be inaccurate. You could find out such a multiple my looking at comparable transaction.
Good post. I came across it via a google search.
I've used similar multiples, and at least for now, come to the same conclusion as you. Since I have career skills that are valued at 90k-100k per year, I would likely have to pay $250-$300k to purchase a business that returns a cash flow of similar value. Then I would also have the cost of interest and/or the opportunity cost on my investment (even at 5% opportunity cost, it is $15k/yr). So for right now, it seems that the best bet is to either buy something that has much more potential that is currently being seen by the current owner or to start something on my own.
Sorry I missed this earlier.
I think the big question is whether the free cash flow included paying someone to manage the business for you.
I used to believe that building a business yourself was the way to go since you're starting from scratch and, all else being equal, it probably costs less to start one than to acquire one that's already established.
But really, 2-3 times cash flow is actually pretty cheap. And if you're able to be frugal with that cash flow and use it to acquire additional operations at 2-3 times cash flow, it won't take long before you're set.
But you're right - it really comes down to whether you have to put in 40-60 hours a week running the show yourself.
So maybe the question should be what kind of multiple would you pay for the cash flow of a business that allowed you to be an absent owner?
@ In The Money,
Yes, I agree the industry can matter, since it can affect the certainty of the cash flow.
@ Dan,
I am still leaning towards buying an existing business. For me, the challenge of starting from scratch is that the cash flow is only estimated. With an existing business, whether below or at potential, there is a known starting cash flow.
@ Brad,
I think cash flow accounts for the cost of employees. Thus, one can increase cash flow by becoming an owner/employee, which eliminates the cost of one salary.
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