So, you’re interested in buying a small business that’s for sale. That’s awesome! But how do you know if it’s worth the asking price? A purchase like this is a big decision, and warrants getting it right.
Does the business have revenue? Is it turning an actual profit? How much debt is on the balance sheet? These important questions play a big part in determining real value, and need answered before purchasing. But how do you determine real value in the first place?
Fortunately, valuing a private business isn’t much different than valuing a public one (i.e. stocks). In this article, I’ll show you 3 easy ways to do it.
Valuation is an art
I’ll preface this article by stating valuation is an art, not a science. The 3 methods we’re about to explore are intended to get you in the ballpark. They’re not accurate down to the dollar or even $10,000.
In reality, a business is worth what someone is willing to pay for it. So, what may seem overvalued to you may seem undervalued to someone else. After all, there are a lot of things in business that are difficult to value. These include:
- Customer relationships
- Intellectual property
- Patents
- Reputation
- Brand
Instead, the valuation methods we’re about to explore should be considered a litmus test. Is the seller’s asking price reasonable? Or is it way too high?
Let’s jump in to figure it out!
Prerequisites to valuation
Before getting started, there are 3 key pieces of information needed to value a small business:
Collectively, these are known as the financial statements. I show you how to analyze each in the links above. Without these, it’s impossible to properly value a business. At least, not with any confidence.
If the business you’re considering purchasing isn’t willing to disclose its financials, or doesn’t generate financial statements on an annual (or more frequent) basis, I’d recommend passing on the investment. Valuing such a business wouldn’t be much more than a shot in the dark.
In some cases, a business may only be able to produce 2 out of the 3 documents. The one they’re most likely to be missing is the balance sheet. But with access to the company’s debts (loans) and tangible assets (property and equipment), valuation can still be performed with the income statement and cashflow statement.
Now that we’ve got the financial statements in hand, let’s dive into each valuation approach.
#1: Market Multiple Approach
If you’ve been around the stock market or listened to Jim Cramer on Mad Money, you’ve probably heard the term P/E ratio. Technically, it’s the price-to-earnings ratio, which is calculated by dividing a stock’s share price by its earnings per share (EPS).
So, if a $50 stock earned $2.50 per share, its P/E would be 20 ($50 divided by $2.50). This is often referred to as an “earnings multiple” or “multiple of earnings.”
But P/E isn’t the only ratio used in stock market investing. There are all sorts of multiples used by Wall Street:
- Price-to-sales (P/S)
- Price-to-EBITDA (earnings before interest, taxes, depreciation & amortization)
- Price-to-FCF (free cash flow)
- Price-to-operating cashflow
- Price-to-gross profit
One good thing about public companies is that there’s tons of historical data; this includes market multiples. And with tons of data, we can calculate averages.
For example, I can look at a 10-year P/E chart of Apple (ticker: AAPL) and see that its P/E averages around 28. So if Apple earns $7.00 per share, I can estimate a fair value of $196 per share ($7 x 28).
Fortunately, the same can be done for private business. Let’s take a look at an example.
Example using price-to-earnings
Here’s a look at ABC Inc.’s income statement over the past 5 years. If you do the math, you’ll find revenue has grown by 10% each year. And that ABC Inc. sports gross margins of 30% and net margins of 16% – not bad.
In 2023, ABC Inc. earned net income just short of $116,000. So we have the denominator in the price-to-earnings calculation. But we still need the market multiple to make a determination of fair value.
One of the lucrative things about the stock market, is that Wall Street tends to assign higher market multiples (i.e. valuations) to public companies than private ones. That’s why companies choose to go public in the first place.
So while Apple’s P/E averages 28 in the public market, it wouldn’t be so rewarded in the private sector. For private businesses, I like to use a P/E of 5 on the low end and 7 on the high end. This is because most small business loans have repayment terms of 5 to 7 years.
Essentially, I’d want to be able to repay my loan within 5 to 7 years using profit from the business. To enable that, I’d need to purchase the business between $580,000 ($116,000 x 5) and $812,000 ($116,000 x 7).
Whether you should offer near the high end or low end of that range depends. How much debt is in the business? What are the terms of the loan? Is there competition? These questions, and many more, need to be considered prior to purchasing.
Example using price-to-sales
Sometimes a company will be unprofitable by design as it invests all earnings back into the business to fuel revenue growth. This happens all the time on Wall Street.
In such a situation, you can value the business using the price-to-sales (P/S) ratio. Keep in mind, the further up the income statement you go, the less accurate the valuation tends to be. For example, a P/E valuation is considered to be more accurate than a P/S valuation.
When it comes to P/S for private businesses, I like to use 0.7 on the low end and 1.0 on the high end. For retail businesses on Wall Street, a P/S of 1.0 is about average, if not low.
Let’s pretend ABC Inc.’s net income is $0 or even negative, but that it has explosive revenue growth. If sales were $732,000 in 2023, then I’d value the business at $512,400 ($732,000 x 0.7) on the low end and $732,000 ($732,000 x 1) on the high end.
#2: Discounted Cashflow
Warren Buffett, probably the most famous investor in history, believes the true value of a business is the sum of all future cashflows discounted back to today’s value. It’s a mouthful, I know.
Basically, a company is worth the amount of cash it’ll produce from now until eternity. But due to inflation, $1 today may only be worth $0.20 20 years from now. And compared to 50 years from now, it’s practically worthless.
By making a few assumptions on future profitability, it’s possible to calculate the sum of all future cashflows, and discount it back to present value (i.e. a discounted cashflow or DCF).
Fortunately, there are smarter people than I who’ve discovered the formula. You can even find DCF calculators online which makes performing a DCF easy.
If you’re looking at the above formula and scratching your head, don’t worry. It’s not as complicated as it looks. But you do need to know a few things and make a few assumptions to perform the calculation:
- How much cashflow (CF) is the business generating (refer to cashflow statement)?
- How much do you expect cashflow to grow over the next 5 to 10 years (5%, 10%, etc…)?
- At what rate do you “discount” the value of future cashflow?
With this information, you can easily value a small business using DCF. You can do so by building the formula in Excel. Or, if you want to cheat, use an online calculator.
Example using discounted cashflow
Continuing with ABC Inc. as an example, let’s assume the company is efficient at turning net income into operating cashflow (i.e. it doesn’t have a lot non-cash expenses like depreciation).
Let’s pretend ABC Inc. generated $115,000 in cashflow in 2023. And similar to net income, has grown operating cashflow 10% annually for the past 5 years.
After reviewing ABC Inc.’s financial history, you’re fairly confident profit will continue to grow at 7% the next 5 years. But that growth will level off starting in year 6. In year 6 and beyond, you assume ABC Inc.’s profits will grow in line with historical inflation at 2%.
As a potential buyer, you’ve secured funding from the bank at an interest rate of 14%. So you elect to use this as the discount rate for the calculation. Another good benchmark for discount rate is the desired rate of return on the investment.
For example, if you’d be pleased with a 10% annual return in ABC Inc., then enter 10% as the discount rate. It’s important to note, the higher the discount rate, the more conservative the valuation.
Taking all this into consideration and plugging it into an online calculator places a valuation of $1.2 million on ABC Inc. But debt also needs to be considered. If the company had $250,000 in outstanding debt (i.e. loans), that amount should be deducted from the valuation, which would yield a fair value of $950,000.
#3: Net Asset Value
The last method we’ll review is net asset value, which is the net value of all assets owned by the business. Net liquidation value is a similar method, and is the value a business would fetch if its assets were liquidated (sold off), repaying all debts first with anything left over going to the owner.
Net asset value and net liquidation value are valuation methods most applicable to businesses in distress. Perhaps competition has moved in and is squeezing profit margins. Or the business is poorly managed, but has a lot of potential. Distressed can mean a lot of different things.
The balance sheet is helpful in determining net asset value, but not absolutely necessary if you have access to bank accounts, loan amounts, property values, etc…
To determine net asset value, you need to consider the company’s assets and liabilities. Assets include items such as:
- Cash and liquid investments
- Inventory
- Property and equipment
- Accounts receivable
Whereas liabilities include items such as:
- Outstanding debt
- Accounts payable
- Tax liability
Net asset value is equal to total assets minus total liabilities, which is a useful metric when considering a fair purchase price for distressed or poorly managed businesses.
Summing it up
As I mentioned, valuation is more of an art than science. When purchasing a small business, there are a lot of things to consider which can’t be calculated. But the 3 valuation methods we reviewed: Market Multiple Approach, Discounted Cashflow, and Net Asset Value, are highly beneficial in helping to determine a range of fair value.
My recommendation is to be conservative in your application of each. Err on the side of caution. Perform all 3 valuation techniques and compare to one another before making an offer. Aim to establish a low range and a high range for the business.
It may not be perfect, but it’s certainly better than throwing darts in the dark.
