How to Value a Business?

Q: I am looking into trying to buy an existing teashop. The owner said to make him on offer, but I'm not sure of the best way to determine the worth of the business. Do I ask to see his books or do I value it based on the existing clientele? What kind of time frames do I need to have to make this a reality? Once I have an offer and it is accepted, where do I go from there?

A: There are a lot of ways to value a business. There's no "right" way, though you could probably come up with several wrong ones. Ultimately, the business is worth whatever you think it's worth, based on the criteria you set forth. But you can make your estimation by using several different ways to value the business and then choosing the mix that reflects your final value estimate.

You can start by looking at the value of the business's assets. What does the business own? What equipment? What inventory? After all, you'd have to buy all the same stuff if you were starting a teashop from scratch, so the business is worth at least the replacement cost. The balance sheet can give you a good indication of the value of the company's assets. If the company doesn't have a good set of books, think twice about buying it. You can get badly burned if the current owners don't even know accurately whether or not the business is profitable.

The other valuation approaches all think of a business as a stream of cash. They value a business by trying to come up with a value for that stream of cash.

Revenue is the crudest approximation of a business's worth. If the business sells $100,000 per year, you can think of it as a $100,000 revenue stream. Often, businesses are valued at a multiple of their revenue. The multiple depends on the industry. For instance, a business might typically sell for "two times sales" or "one times sales." If you have a good stockbroker, he or she may be able to help you research typical sales multiples for your industry. A good business broker can also help you if he or she has done valuations in the industry you're investigating.

But alas, revenue doesn't mean profit. If you're in doubt, just look at Amazon.com: It had 2002 sales of almost $4 billion, but no profit. In fact, it hasn't made one cent of profit since the day it was founded. How much would you pay for an ongoing $4 billion per year that you have to pump an additional $380 million per year into just to keep it afloat?

That's why earnings matter and why multiples of earnings may be a better way to think about valuation. If a company had a profit of $10,000, that cash can be used for growth or dividends to you, the shareholder. Estimate the earnings for the next few years and ask how much that income stream is worth to you. Be careful, though. Don't just assume earnings will be stable. Competition, supplier price changes and a declining industry can affect earnings. Make sure to reflect that in your projections.

Warren Buffett uses what's called a discounted cash-flow analysis. He looks at how much cash the business generates each 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's no room to explain the theory or calculation here, but you can do it in Excel using the NPV "net present value" function.

One quick and dirty technique is to divide the current yearly earnings by the long-term Treasury bill rate. For example, if the shop earns $10,000/year and T-bills are returning 3 percent interest, the business is equivalent to $333,333 worth of T-bills ($10,000/3 percent=$333,333, so $333,333 invested in T-Bills would return the same $10,000 income). So if you had $333,333, you could earn your $10,000/year by investing in T-bills with a lot less effort than running the shop. This technique puts an upper limit on your valuation. After all, why would you spend more than $333,333 on a store when you could earn more by spending the same money in T-bills? Of course, using this quick-and-dirty technique assumes that the teashop will have the same earnings year after year, and assumes that only monetary return matters.

These techniques-asset valuation, sales multiple, earnings multiple and cash-flow analysis-value the financial side of the business. Nonfinancial considerations also come into play. You might pay more for a teashop if it's next to a restaurant you own, since the combined business may be worth more. Or maybe you've just always dreamed of owning a teashop. Be careful with letting your dreams influence your valuation too much, however. My friend Vinnie always wanted to own an occult supply store. He got his wish, but not a good valuation. It cost him years and much heartache to dig his way out of the situation.

I hope these ideas give you a head start in valuing the business. I'd also recommend you get your banker involved in the valuation. Since your banker will be helping finance the business, he or she will have a good sense of how to do a good valuation for shops in your area.