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Transcript:
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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