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Hey there it's David Barnett once again with another viewer question. This time it's from Michel, and Michel asked, what are the different ways to evaluate a business that's for sale? And basically the methods that we use when evaluating a business fall into one of three camps. Let's take a look. So our methods of small business fall into three different camps or schools of thought. The first one being market comparison. So if you wanted to have a business evaluated as a buyer or a seller, and you went to someone who had the proper training skills and access to information on how to evaluate a small business. One of the things they would actually do is actually compare the subject company that you are looking at with other businesses in the same industry that have already sold. And what they want to do is compare similar businesses and similar size businesses. And what they are going to find is what other people have paid as a percentage of sales and as a factor of discretionary cash flow So the database might come back and tell me that a given company might sell for; other people paid about 32% of sales for example, or they paid 2.4 times discretionary cash flow. So we are actually comparing the subject company with other businesses that have sold. And what we are doing is that we are actually getting the feedback of all those previous buyers and more listening to their opinion of what they thought the risks were in getting into this industry. So that by far to me is one of the best way to evaluate a business.
The second group is the capitalization or I put mathematical methodologies. Because basically what we are doing in this case is we are trying to determine what rate of return is going to make us happy. What do we want to see happen at the end of the day if we were to own this business? Are we going to require a 20% return on our investment? Are we going to require a 40% return on our equity that we put into the deal? So there are many different ways that you can look at it from a mathematical point of view. And if we are looking for a certain percentage, these are often called capitalization rates. Cap rates are used quite often for example in the real estate evaluation area. The other way to look at it is multipliers which is the same thing, just from a different point of view. So you might hear people say that certain businesses sell for three times earnings for example. That would be an example of a mathematical or capitalization type method of business evaluation.
The third category will be simply looking at the assets involved. So I call it asset evaluation or cost to create, where you are going to look at, what are the tools, equipment, inventories, receivables, operating capital etc. required to make this business function. If I were going to take a subject company and recreate the same thing next door, what would it cost me? Now part of this can be done from the balance sheet of the company, but to really do it accurately you would actually have to evaluate and find out what the market value was of certain assets within the business: hiring appraisers, evaluators, this type of thing. So the one thing though that this group of methodologies doesn't include or leaves out is goodwill. So if we have a profitable business that makes money all the time, then it's conceivable that there would be a goodwill component to any value for that business. And this would be left out using those methods. Now when I evaluate businesses, I actually try and employ these three groups and methods. There are 13 specific methodologies that I use when I'm doing an evaluation. And I don't employ all of them in every case. But I try to have at least one from each of these three groups.
It can be informative for example when you are setting up your deal structure that you might offer an amount of money that included goodwill. So your offer might be based on a market evaluation or a capitalization method, but perhaps you don't want your down payment amount to be greater than the asset or cost to create. So that the amount that you are asking the vendor to finance, the vendor take back is in fact largely the goodwill component, which makes it safer for you and makes financing more easy. So I hope that answers your question Michel. If you want to see in detail how these things get applied, then what I suggest is that you take my business buyer course, which is available at businessbuyeradvantage.com where we actually take an example company through the entire process. We look at the financials, we do a normalization, we then do an evaluation and I show you the different methodologies and they get applied. Thanks and we'll talk to you soon. Have a great day.
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