Determining Business Value – The Income Method

Determining Business Value – The Income Method

Hi, Steve Schlagel here. I promised you that
I would give you a way to do a real rough valuation of a business using what we call
the income approach. Now, business brokers and other have different rules of thumb that
they use and those are valuable often times they get you into the ballpark of what a business
might be worth. But I like to have a common sense approach, and it’s more than just common
sense because there’s a lot of science to it and how we actually use it as certified
valuation analysts. But, this is just a way for you to think about it. In the income approach
there are two numbers that are really important and you see them right here. Cash flow, you
can also use income but I like to use cash flow, cash flow and cap rate. When you know those two numbers, you can determine
an estimated value. For instance, if our cash flow was $100,000 a year and we wanted a 25%
return on our money, a cap rate, 25% return on our money is the equivalent of a four times
multiple. So $100,000 of cash flow times four is $400,000. That would be the amount I would
be will to pay. Why? Because the $400,000 times a 25% rate of return would get me that
$100,000 a year of cash flow that I need. The trick is, though, what is cash flow? You
can take the financial statements or tax returns on any business and you can begin to look
and see what sort of cash the business generates each year. When we do valuations we often
look at the last five years and we average them, either a straight average of the five
years or we do a weighted average depending on how we think the market is changing. But
just to keep it simple, let’s say it’s a straight average. So you could add up the cash flow for each
of those five years and then divide it by five and you’ll have your average cash flow
to take and use with the cap rate. The trick though on cash flow is that you don’t just
take the number off of the financial statements but you make some adjustments to it before
you use it. You need to look and see what kind of expenses are in there. A lot of small
business owners run a number of questionable expenses though their tax returns. Let’s say
that you’re looking at a particular business and in one of those years the owner purchased
a boat to use at his cabin and he decided to put it on his tax return and call it an
entertainment facility. Seen it done. You’d want to take that out because it’s not an
ordinary and necessary expense of the business. And that’s the test, Is it an ordinary and
necessary expense of the business? So we try to clean that up. You might find people running
fuel for their vehicles, for their personal vehicles through there, personal telephone
expenses, fees to professionals for personal things that they run though their business.
People are very creative in what they put in there. So you want to clean it up so that
you understand what this cash flow is on a normalized basis, what would be normal and
not necessarily what all did that business owner run though there. So once we’ve cleaned
up that cash flow and we’ve got a number, then we need to move on to determine what
the cap rate is. And, determining cap rate is a complicated process, and I said I would
give you all a little bit of a rule of thumb here, so I’m going to give you some ranges
of cap rates that you might consider. If you want to get into the detail, I have
some articles on my website that walk you through in a little more detail how to determine
cap rate. But for our purposes here, I often find that a lot of small businesses sit without
risk factors somewhere between 20% and 33%. The higher that percentage, if you said I
want a 33% return on my investment, that means you think that particular business is more
risky than a business that you would only require a 20% rate of return. You’ll accept a lower rate of return when
you believe there to be a lower risk. But most small businesses fall somewhere in that
20 to 33 percent range. And so a 20% rate of return is a five cap rate, a 25% rate of
return is a four, and a 33% is a three. And so, once you have determined this cash flow,
you could say the multiple that I would apply to that might be three, four, or five depending
on how much a risk I think there is. Three, being there’s a lot of risk and five being
there’s a lower risk. Now that’s not perfect and I’m just trying
to give you a way to think about it. Something to compare against that business broker’s
rule of thumb that he might be using or that some of your friends are telling you. Just
another way to look at it. If you find that in doing that numbers are quite a bit different,
that might be an indication or a reason why you might want to go visit with a valuation
analyst in your area and hire them to evaluate a particular business you’re looking to buy
or sell to really hone in on what the rate really is. Rules of thumb and shortcuts like
I just talked about are imperfect by their very nature, but I wanted you to just at least
understand the basics of how you begin to determine value of a business using the income
approach as we just discussed here.


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