How to value a business venture?

If you are interested in purchasing an existing business venture, you must read this article which will help you with a few ways to gauge its value.

There are a lot of methods and techniques to value a business. There is not any single perfect and right way and thus you can come up with your own ways. Eventually, the business is worth whatever you think it is worth i.e. based on the criteria you set forth.

You can make an estimation by using several different ways to value the business and then choosing the mixture that reflects your final estimated value.

You can go ahead by looking at the value of the assets of the business. You would have to look at what does the business own that means kind and value of equipment and inventory. This is because you would have to buy all the same equipment and usable stock that the previous owners used in the business like if you are starting that business from a scratch, so the business is worth not less than the replacement cost.

Read: Getting a bank loan for Startup Business

The balance sheet (Statement of financial position) of the business can give you a good indication of the value of the assets of the company. If the company does not have a complete, good and transparent set of books, reconsider your decision to buy it. You can get hurt badly and incur heavy losses if the current owners of the business do not even know accurately whether or not the business is profitable.

The other valuation approach everyone thinks of a business is the “stream of cash.” You can value a business by trying to come up with a value for that stream of cash.

Revenue generated by the business is the crudest approximation of its worth. If the business sells 100,000 dollars per year, you can think of it as a 100,000 dollars revenue stream. Usually, businesses are valued at a multiple of their revenue and the multiple depends on the industry.

For example, a business might usually sell for “two times sales” or “one-time sales.” Now, if you have got a good stockbroker, s/he may be able to help you research typical sales multiples for your industry. A good business broker can also help you if s/he has already done valuations in the industry you are investigating.

But unfortunately, revenue does not mean profit. If you are in doubt, take an example of the most popular online shopping giant, amazon which had 2002 sales of almost $ 4 billion, but no profit at all.

That is why earnings matter and why multiples of earnings may be a better and suitable method to think about valuation. If a company had a profit of 10,000 dollars, that cash can be used for growth of the business or dividends to the shareholders. You must estimate the earnings of the business for the next few years and ask how much that income stream is worth to you.

Be careful and do not just assume earnings will be stable. Competition, supplier price changes, and a declining industry can affect earnings pretty well, so make sure to reflect that in your projections.

Warren Buffett, an American business magnate, Chairman, and CEO of Birkshire Hathway, uses a technique named discounted cash-flow analysis. He looks at how much cash the business generates every year, projects it into the future and then calculates the worth of that cash flow stream discounted using the long-term Treasury bill interest rate.

There is no room to explain the theory or calculation here, but you can do it in Microsoft Excel or any other spreadsheet using the NPV (Net Present Value) function.

One quick and dirty technique is to divide the current annual earnings by the long-term Treasury bill rate. For instance, if the shop earns 10,000 dollars per year and Treasury bills are returning 3% interest, the business is equivalent to $333,333 worth of Treasury bills ($10,000/3% = $333,333, and so $333,333 invested in Treasury Bills would return the same 10,000 dollars income).

So if you had $333,333, you could earn your $10,000 per year by investing in Treasury bills with a lot less effort than running the shop. This method puts an upper limit on your valuation of the business.

After all, why would you spend more than 333,333 dollars on a store when you could earn more by spending the same amount of money in Treasury bills? Certainly, using this quick-and-dirty technique presumes that the business you are thinking to buy will have the same earnings year after year, and presumes that only monetary return matters.

These techniques i.e. the asset valuation, sales multiple, earnings multiple and cash-flow analysis, value the financial side of the business enterprise. Non-financial considerations also have a role to play.

You might pay more for a business if it is next to a shop or any other related business you already own, since the combined business may be worth more; or perhaps you have a dream of owning a that particular business. However, you should be very careful about letting your dreams influence your valuation too much. My friend John dreamt of owning an occult supply store and soon he got his wish true, but he did not make a good valuation. This cost him years and unbearable pain to dig his way out of the situation.

I hope these ideas and techniques gave you a head start in valuing the business ventures. I would also recommend you get your banker involved in the valuation process. This is because your banker will be helping finance the business, so s/he will have a good sense of how to do a good valuation for shops in your area/locality.

Hope this article helped you to do the valuation of the business you are thinking to buy in a much better way.