Rule-of-Thumb Valuations

• Rule-of-thumb valuations can be useful for nearly every type of business. However, as gross simplifications, they usually fail to address the individual characteristics of a particular business and the individual characteristics of a particular buyer. Accordingly, they should only be used as a general framework to establish an appropriate price range for a certain type of business.
  
  Practical valuation solutions should be grounded in the realities of economics that take into consideration the influences of supply and demand, the available cash flow of the business to pay off a loan and how the deal can be structured so it's appealing to prospective sources of financing. "Cash" transactions may have an entirely different price and structure than deals requiring some type of financing.
  
  

Market Based Valuations

• The comparable sales method is based on identifying the selling price of "similar businesses" that have "recently" sold in the seller's area. The method is identical to that used in the sale of residential homes. Emphasis is placed on the terms "similar businesses" and "recently sold" for this method to have any practical meaning.
  
  There are averages for many businesses across a wide range of industries that are published by industry trade associations and other sources. These averages are favored by business brokers and agents because they provide a starting point in arriving at a final valuation. Caution is stressed in using industry averages due to unique circumstances relating to a specific business. These unique circumstances might include: owners reason for selling, profitability of the business, location of the business, competition and degree of risk.
  
  The Price/Earning ratio method is only mentioned because it is common among publicly traded companies. The P/E ratio has little relevance for privately owned companies. The ratio is derived by taking the price of one share of common stock and dividing that by the earnings of one share. That number is then multiplied by the total number of outstanding shares of common stock.
  
  

Asset Valuations

• These valuations have little relevance in a market for an "on-going" business because asset valuations are typically used for liquidation or "fire" sales. The basic formula involves fully depreciated tangible assets minus the liabilities to arrive at the net worth of the company, the net worth being the value of the company. Asset valuations take no consideration for intangible assets such as customer lists, goodwill or adjusted current market value for plant and equipment.
  
  

Historical Earnings Valuations

• All historical earnings valuations have as their common objective the ability to retire the debt incurred to buy the company and to provide the buyer with a desired return on his down payment investment. The basic concept involves arriving at a "free cash flow" number by restating the historical financial statements to eliminate excessive salaries and perks, and all non recurring income and expense items over a three to five year period. The remaining figure is the amount available for debt service and the new owner's salary, or the new owner's desired return on his down payment investment.
  
  

Terms of the Deal

• Prospective sellers of businesses are advised that flexibility may be critical in selling a business because few buyers will have available resources to engage in a cash transaction. Most buyers will have to secure some form of external financing to consummate the deal. In this regard, the lending source will become an integral part of the transaction that will likely impose covenants and restrictions on both buyer and seller. In addition, sellers who demand a hefty down payment may place themselves out of the market because the adjusted cash flow after the sale may not be sufficient to provide the needed return on investment to make the deal feasible.
  
  In the final analysis, flexibility is the name of the game because valuating a business is far from an exact science. Sellers and buyers should both look at the transaction from the perspective of the other party, particularly the selling price as it relates to deal structure.