PART III: Four Basic Business Valuation Techniques.
1. Comparable Transactions Technique:
Thousands of businesses in America are bought and sold every year. Since some of them are similar to your business, it only makes sense that you could ask for a comparable selling price? That’s the general idea behind the comparable transactions technique of estimating fair market value of your diesel repair shop.
There are three benchmarks to determine value through comparable transactions:
a) Identify comparable transactions of purchases and sales of businesses similar to yours. This will require some research to identify recent sales of comparable businesses to get information about those businesses (profitability, size, products and services, and more). This information is needed to determine if the business sold is truly comparable to yours. Business brokers, industry trade associations, and the internet can be useful sources to get this information.
b) Make adjustments for the key differences in businesses. No business is totally identical to yours, so don’t expect to find a perfect match with any of the ones you are comparing it to. Use the available information to identify the most important differences and make appropriate adjustments.
For example, if a comparable repair shop is twice the size of yours you’ll have to scale down the selling price to half the amount to get a reasonable indicator of what your business would sell for. If they offer products or services you don’t, then you may have to reduce the price to reflect your narrower line of business. If your repair shop has a higher growth rate than the comparable shop, then you should raise the price to reflect that as well.
There will always be differences to take into consideration, no matter how similar a comparable business is to yours. The adjustments you make will often be a matter of judgement rather than mathematics, but even making an approximate adjustment is better than not making any adjustment at all.
c) Establish the range of fair market value for your business. Don’t expect to come up with the same adjusted sale price for all your comparable businesses. That won’t happen. What you can expect is to identify a range that your business’s fair market value will fall within. With that range as a guide, you can use your judgement to determine if your business value is on the high, middle, or low side of the range.
2. Industry Norms and Guidelines:
There are often guidelines, or rules of thumb, in most well-established industries to give you a general idea of business value. Within every industry, businesses differ greatly, so the use of industry valuation guidelines is merely a “first pass” approximation of fair market value. But these guidelines can give you a useful “ballpark” figure, despite all their inaccuracies.
There may not be a formal source for you to look up and learn about these guidelines. You may have to reach out to knowledgeable people with access to resources about your industry. Searching the Internet, contacting trade associations, business schools, and specialized consultants are always a good place to start.
Before moving on to the next method for estimating fair market value, it’s necessary to take a closer look at earnings as an investor would look at them.
Company earnings are the accounting net profit after taxes that you report in your annual income statement. But for purposes of estimating fair market value, earnings can be much more. If you look at the value of your repair shop from the perspective of a buyer or investor, earnings take on a different meaning. Earnings, to the outsider, mean annual cash flow generated by the business that is or will be available as a return on investment.
For owner-operated small businesses, for the purpose of estimating company value, annual earnings include the following:
- The accounting net profit;
- Excess owner’s pay – the amount the owner pays himself/herself above the amount a hired general manager would be paid for the same job. Often, potential buyers add back the entire owner’s salary to estimate earnings;
- Depreciation and amortization expense and any other non-cash expenses on the income statement;
- Discretionary expense items. Any expense that cannot be justified by the company’s business;
- Extraordinary one-time expenses or revenues.
The value of your repair shop is highly dependent on its future earnings. So the way you forecast annual earnings and how well you justify your forecasts is critical.
Most “financial” buyers – those looking only for a return on their investment – look at your past earnings and project them into the future. If your business is growing, or in any way deviates from past performance, you’ll have to present a persuasive case for your earnings forecasts.
On the other hand, “strategic” investors – those seeking a business alliance – want to know your future plans, the impact of your business on their company, and the risks involved.
If you’re actually selling your diesel repair shop, and the potential buyer is a strategic investor looking for strategic benefits, you should adjust your earnings forecast to reflect the earnings benefits that would be realized by the buyer. It can be difficult to estimate, but if you don’t, you’re undervaluing your business and starting your negotiations from a lower asking price than you need to.
3. The Price-to-Earnings Ratio
Published stock prices are similarly useful and also provide you with a simple way to make a “ballpark” estimate of your repair shops value. If there is a publicly traded business similar to yours (except in size), you can use their share prices as a way to estimate the fair market value of your business.
For any business, the price per share divided by the earnings per share is the same number as the total market value of the business divided by the total earnings of the business at the same point in time.
If you add up the market values of all the individual shares of a business, you’ll get the market value of the entire business based on actual current stock purchases. If the stock prices reflect the general perceptions of the value of the business, which virtually everyone agrees they do, then the stock prices of all outstanding shares of stock adds up to the total value of the business. So the P/E ratio of a business tells you the relationship between the earnings of the business and its value.
There are three simple steps for estimating your company’s value from stock market P/E ratios:
1. Select a company (or several companies) that are similar to yours, except for size, and are publicly traded and listed on one of the stock exchanges.
2. Look up the company’s P/E ratio in the newspaper or through a data service.
3. Multiply the P/E ratio times your company’s earnings.
This a very approximate method of valuation because there will most likely be significant differences between your business and the ones you look up. So you will need to do some research to identify the ones that are reasonably similar to yours.
4. Investor’s Rate of Return
Perhaps the easiest way to estimate the fair market value of your diesel repair shop is to look at it as a financial investor would. A financial investor has to determine how much they are will to invest in a business in order to receive adequate future earnings from it.
Most investors think in terms of rate of return and risk. What will be the rate of return for the money they invest? The greater the risk, the higher the required rate of return. There are general guidelines, based on business size, that investors use to determine their level of risk and the range of returns they expect for the amount of risk they’re taking.
Knowing the rate of return an informed investor would expect for buying or investing in your repair shop, it’s easy to calculate the appropriate fair market value. For instance, if the investor requires a 20% return for buying your buying or investing in your business, and your business has earnings of $120,000 per year, then you would need to answer the question, “$120,000 is 20% of what?” The answer would be $120,00 divided by 0.20, or $600,000. The investor would be willing to invest $600,000 to receive an annual cash flow of $120,000. Here’s the formula:
Estimated Fair Market Value = Annual Earnings divided by Investor’s Required Rate of Return
This technique has the implied assumption that your earnings will be level in future years and it ignores the time value of money. If your business has any growth expectations at all, the investor’s rate of return method understates its real value.
Business Valuation – It’s an Art and a Science
Unfortunately, business valuation is an exercise in false precision. Whichever technique you use, you’ll always arrive at an estimate of value – a number – which, like all numbers, seems exact. But in business, any number is worth only what goes into it. Before you make any decisions based on your number, you first have to know what the number means and how it was derived.
Company fair market value is one of the most important numbers you’ll ever use in business. But you need to consider the shaky foundation on which it is built. The calculations are clear and precise, but what about the numbers that go into the calculations? What is the appropriate investor’s time horizon? What is the “right” required rate of return? What are the earnings, really? How reliable are your forecasts? How will the economy affect your business in the future? Even if you had the answer to all these questions, you still don’t know the real market value of your business until you sell it. The science is the easy part. It’s the art that’s tricky.