What is the value of my business?

[schmellen]

well, I know of course that it is worth millions! to my regulars maybe, but how do you value a business? I have a lot of decisions to make in the next few months, and having a clearer picture than the muddle in my head would be great. We rent our space, so the building has no value. But the rest of it, well, where do I start?
Thanks for your thoughts.
JoEllen

 

[FXAdam]

That can be a pretty complex question.

A method that is often used to price something is to look at what is called the Present Value (PV) of the asset's future cash flows.

What that means is that you estimate how much profit the business will make in the future and then express that amount in today's dollars.

That in itself can be a bit tricky because you need to come up with something called a discount rate that you use to bring the future amounts into today's value. Basically it is kind of built around what kind of return you would want to earn if you had the actual amount of the PV in cash and invested it in something.

For example: Say I have a business that I expect will generate $100 of profit in each of the next 3 years and I want to generate a return of 10% on my money.

I need to express each of those $100 amounts in today's dollars which looks like this:

PV of $100 received in year 1 = 100/1.10 = $90.90
PV of $100 received in year 2 = 100/1.10^2 = 100/1.21 = $82.64
PV of $100 received in year 3 = 100/1.10^3 = 100/1.33 = $75.13

Add up those three values to get: $248.67 as the value of my business.

That gives you a base number to work with, and some idea as to what you should be asking someone else to pay.

Rereading that I can see that might be a bit technical so feel free to ask some questions if you want. Go look up something called the "Time Value of Money" and that ight help as well.

 

[schmellen]

wow, I'm a little dizzy

Thanks for the answer, Adam, because a quantative method is what I am looking for. Do I calculate the profit based on current profit and growth? Is three years the average amount to base my calculations on, or more (we are open almost 8)?
I know that there are other questions I should be asking...
Thanks again for the detailed answer. Selling, I think, is more of a fantasy than reality, but I think I need to know if I have a viable escape plan or not.
Take Care,
JoEllen

 

[ElPugDiablo]

To evaluate a business using time value of money theory the first assumption is that the business is profitable and therefore there is a positive return for the investor. In buying and selling small businesses, one thing you have to realize is that as much as you valued your business, the buyers are going to view it as a high risk investment, and require substantial returns for the risk they they take. I have heard people use 33% to 50% return on investment (ROI) as a guideline. Another thing to keep in mind is that future profitability is very hard to predict so investors are more interested in past results, the most recent one in particular. So if you made 100,000 in profit before taxes in the last 12 months, using 50% ROI, your business is worth 200,000 (100,000/50%).

Now, what if let's say you invested a million dollars into your place but it is not yet profitable, and it is not likely to be so in the next three year, is your business worthless? Of course not. In such a situation you need to look at alternative methods of business evaluation. The most common being replacement value plus location consideration.

If you really want, there are professional accounting firms specialize in small business evaluation. They will ask you a bunch of questions, and plug your answers into a fancy schmacy software costing 5K that spit out a report, and they will charge your 5K for the report. How's that for ROI?

 

[FXAdam]

Re: wow, I'm a little dizzy

Do I calculate the profit based on current profit and growth? Is three years the average amount to base my calculations on, or more (we are open almost 8)?

Three years is just an example. Really you want to go as far ahead as you think you can reasonably predict. The amounts added to the PV after you get out even 9-10 years won't be very big so don't get to bogged down in your forecasts. Predicting that far in the future can be very unreliable as well so you really need to take those numbers with a grain of salt.

Use you current profit plus whatever you think your growth rate is. Try a few different scnarios with good, mid, poor growth rates and things like that so you have an idea of a range the value of your business might be in. Don't assume your growth will continue forever either. There is likely a plateau in sales volume you will reach for a given location. Even if you serve at full capacity every hour you are open there is still a maximum amount of revenue that will generate if you know what I mean.

 

[FXAdam]

To evaluate a business using time value of money theory the first assumption is that the business is profitable and therefore there is a positive return for the investor.

This is a good observation. There are other valuation techniques you can use to get around that problem such as looking at the Free Cash Flow the business generates after certain classes of your expenses are subtracted. That can get a bit complicated to explain though and I'm not going to do it here unless someone really needs it.

In buying and selling small businesses, one thing you have to realize is that as much as you valued your business, the buyers are going to view it as a high risk investment, and require substantial returns for the risk they they take. I have heard people use 33% to 50% return on investment (ROI) as a guideline.

That is pretty scary. 50% discount rate is going to turn your PVs into effectivly nothing pretty quick. Anything past 3 years is a waste of time at that rate. It makes sense that rates like that get used though given the high risk you mention. There is no question a coffee business is going to garner that kind of perception.

Another ...

If you really want, there are professional accounting firms specialize in small business evaluation. They will ask you a bunch of questions, and plug your answers into a fancy schmacy software costing 5K that spit out a report, and they will charge your 5K for the report. How's that for ROI?

Might be worthwhile, maybe not. Depends on how big a deal you are really talking about. It never hurts to get a third party evaluation.

 

[ElPugDiablo]

That is pretty scary. 50% discount rate is going to turn your PVs into effectivly nothing pretty quick. Anything past 3 years is a waste of time at that rate. It makes sense that rates like that get used though given the high risk you mention. There is no question a coffee business is going to garner that kind of perception.

Unfortunately retail food business has one of the highest failure rates, so yeah a heavy risk premium is attached. 50% is high, but sometime justified. Most average shops are at 40%. Exceptional shops can command a discount rate as low as 25%.

Another hard thing about evaluate small (cash) business, is getting precise data. More often than not a seller will say my rev is 500K, but only 300K is on the book. So do you make decision based on 500K or 300K? I knew of a restaurant that went on the market; and while it was on the market the owner ran deep discounted specials and packed the place, and he fooled potential buyers with a false sense of booming business.

 

[dant]

Interesting point about the money on the books vs the real numbers. I know there is a temptation to skim off the books to save on taxes but in the long run you end up only hurting yourself. To get any loans, either for the business or a personal mortgage, you gotta show that income on your tax return. And as you are pointing out you need that income on the books when you go to sell--by skimming to reduce your profit on the books you'll end up devaluing your business way more than you'll save on taxes.

-Dan