Figuring a Company's Value

How much is a company worth? Perspectives on valuation. March 14, 2005

In a relatively simple formula, how do you figure the value of a company? I will take the long versions, too.

Forum Responses
(Business Forum)
From contributor T:
This month's Inc. magazine has a huge section on company valuation, and has a few articles on finding investors. It's an incredible resource. It stops you from thinking like a tradesman and puts you in touch with the other 95% of the business world.

From contributor S:
In one of my past lives, I was a business broker and valuing small businesses was something I did a lot of. Most small businesses are valued on a multiple of owner's benefit. That is the sum of the profits, plus the owner's salary and perks (car, phone, etc.), add inventory but not equipment. The equipment simply generated the benefit and is worth nothing more than liquidation value otherwise. It has been my experience that most small business owners have a warped sense of what their business is worth in the real market. Multiples vary by industry but 3X is probably average.

From contributor Y:
I work as a volunteer for SCORE and this question comes up quite frequently. One way to think about it is this: Try to calculate how much profit the company would generate for you if you had no duties or responsibilities except to count the money. That is, if you had managers, secretaries, accounting services, salespersons - whatever was required for the company to function entirely by itself. Multiply times 5 and then add the value of readily saleable assets such as good machinery, land, buildings, etc.

This formula is based on the idea that a willing investor would make 20% on their money if they bought your business and, since they do nothing, would be able to benefit at a level far better than a stock investment (to compensate for risk). Since they don't need to do much, and don't need to understand much, the range of buyers can be quite good, and potential buyers should be able to borrow some of the money to purchase your interest. If you think 20% is too generous, change the number and the corresponding multiple. If you think that your business is growing naturally, project the future profit.

From contributor P:
How many (or what percent of the) businesses meet that criteria? I suppose all franchises would, but other than the franchises? I have to think that it is an incredibly small percentage. This is an interesting goal that makes us look at our businesses in a new light.

From contributor Y:
I think it applies to any business that is truly saleable - franchise or not. Why else would a buyer invest their money in a business as opposed to a good stock or bond? A business has to return an increment that is similar to the stock or bond and for the same amount of effort. Namely, none. And it has to offer a higher return due to the additional risk. This doesn't have to be 20% but it has to be something persuasively higher than 7-8%.

It's true, true, true that many small operations don't meet this criterion. And they are pretty hard to sell, as a consequence. But the problem is that most small operators have their salary and the profit confused. If an owner is paying him/herself $100,000 a year, and could hire a manager for $35,000 to do most or all of the same work, the confusion is only one of accounting. What is really happening is that $65,000 is being wrongly attributed to salary. If, on the other hand, the owner is getting $35,000 for a typical owner's work week, then a business can't be worth much more than the value of the fixed assets since all it offers is the freedom (and headache) of being able to fire oneself.

Of course, an owner can pay themselves $35,000 to keep prices low and build market share, but the assumption here is that eventually, the business will be big enough to afford a more handsome salary. More often, the owner's salary is kept at this level because one's competitors are undercutting sound prices and the owner is forced to compete. The problem here is that these (implicit) discounts are leaking all the value out of the business to benefit consumers. This is the down side of the free enterprise system.

At the end of the year, a mature business needs to be able to pay all the requisite labor and still show a profit of about 20% of its saleable value (not 20% of its sales).

There are all kinds of adjustments that need to be considered in a specific case. For example, how many business owners really need to buy that 3/4 ton dually with the Cummins Diesel? What about that digital camera? How about the trip to the woodworker's conference in Aspen? What about the 30% per year growth rate? Indeed, what about the fact that the business owner has been beating up his/her accountant for years to show as little profit as possible?

But in the end, one has to return to the practical facts - a potential new owner is going to buy a business because it is a good investment. And that calls for profit. It can't be otherwise.

From contributor S:
Don't forget the owner who has done a lot of "off the books" work for cash. I ran into that a lot - they either did do cash work, or would claim they did to offset the fact that their profits were too low. Either way, it can't be documented and a buyer will not pay for it.

From contributor Y:
This is very true. It comes up a lot in the restaurant trade. I think that the only way to sell a business that has been skimming cash is to say "Here's the price. Take it or leave it." But even if the buyer understands the underlying implication, it telegraphs a bad attitude and all the rules drop by the wayside. Makes it tough to get a loan as well. It's a crime to skim off cash and I think it's a mistake.