When investing in any type of business, one of the most important things is figuring out how much you should pay for it. Unfortunately, no two businesses are the same, so there is no standard way to determine price.
Business owners who have sold their companies tell very different stories about what they were offered for theirs. There are many reasons why this happens, but one major factor is whether the buyer believes that the current market value is fair or if they feel like the company is undervalued.
If you’re considering buying a business, make sure you do some research and understand the values of similar companies. Also, don’t assume anything about the future! A lot of times sellers will agree to a lower sale because they believe that they can get more money later.
There are several ways to evaluate the worthiness of a business, and your final number may depend on which method you use. The best way to know the true value of a business is by looking at both online and offline data about its earnings, profits, and capitalization. All of these factors play an integral part in determining the business’s value.
The vast majority of business buyers hire professional asset specialists to help them find and analyze potential investments. These professionals have specialties such as accounting, finance, economics, and marketing, among others. By having experts aid you in assessing the business, you increase the chances of getting a sound evaluation.
- 1 Calculate the potential value of the business
- 2 Look at the business’s growth rate
- 3 Consider the business’s market niche
- 4 Look at the business’s financial health
- 5 Calculate the return on investment
- 6 Negotiate until you get a good deal
- 7 Take a financial snapshot of the business
- 8 Do you like the business?
Calculate the potential value of the business
The most difficult part about valuing a business is figuring out how much it is worth! There are several different approaches you can use for determining market value, but none are definitive or clear cut.
The easiest way to value a business is by using the price/sales approach. This method assumes that what a company sells like products in the past means it will be successful in the future. By looking at sales data for similar businesses, you can determine an average cost per sale, which then can be adjusted up or down depending on whether the business was undervalued or over-appraised.
A more advanced technique is to apply the earnings approach. Here, you look not only at past revenues, but also current and predicted future revenue. You can add in costs such as payroll, marketing expenses, and technology systems to come up with a total valuation.
However, both these methods have their drawbacks. With the first one, you cannot easily compare apples to oranges – if Amazon does not sell laptops, for example, then this pricing model won’t work very well. Using the second approach, companies that do not put forward effort into keeping costs low will skew the results.
As hard as it may be, try to avoid thinking in terms of ‘what I think the business should be sold for’. A lot of times, people who own struggling businesses feel pressure to accept a lower offer because they want the money in their pocket.
Look at the business’s growth rate
The next factor in determining if a company is undervalued or overvalued is looking at how well the company has done compared to its own past performance. Looking at the company’s historical performance can help determine whether the current price is too low or too high.
A common way to do this is to compare the market value of a firm with what it was two, five and ten years ago. This gives you an average of what the stock is worth at each point in time. By figuring out which year is the lowest and highest, then comparing that to now, we are able to get an estimate of how much more or less the stock is worth today than it was back then.
This comparison process is also referred to as “dollar-value investing.” By investing money in stocks that have shown consistent growth, your dollars grow consistently. It is important to note though that while this may be a good thing, it does not always represent a fair valuation for a company.
For example, let’s say Company A had a bad year last year but they made huge investments in their product line that will make them even better this year. They could easily win back the lost reputation and confidence in their products. Because of these new developments, people re-calibrate the cost of Company A’s products and give them a higher price tag.
Consider the business’s market niche
A good way to determine the value of a business is by looking at its market size. What is the market for or gap in the market that this company fills? And how much profit does it make while filling that gap?
Businesses are not worth what they could be sold for, but rather what their owners believe they are worth. This means going into the business with your own internal valuation – what price you place on it yourself.
By comparing the business’s market position to similar businesses, you can get an idea of how much it is worth. The average sales price of companies in its field is a great reference point.
Another method is to look at whether the other firms in the same area remain profitable. If so, then they present proof that the market believes the firm has solid potential. Depressingly though, many don’t! Many lose money or even fail!
That doesn’t mean the business isn’t worthy however, only that others have given up trying to turn it around! By studying why these other ventures failed, you can learn from their mistakes and potentially save yours.
Look at the business’s financial health
When investing in a business, one of the most important things to consider is how well the business is performing financially. Obviously, if a business has gone bankrupt, this puts more pressure on you as an investor because you now have no way to access the resources it had.
But even if a business is just not making enough money, this can be a great opportunity for you. This may sound crazy but there are actually many cases where people invested in a business that was struggling, and ended up getting a lot of value from owning it.
A few examples include buying a restaurant that was under-staffed and overpriced, or acquiring a retail space that needed some renovations but was within your budget.
It’s hard to know whether investing in a business will work out well until you try, so don’t worry about wasting money by trying to find out! Instead, focus on spending what you can afford to invest in order to maximize your returns.
Business owners spend a lot of time thinking about ways to improve their businesses, and sometimes they share these tips with other entrepreneurs, etc. By listening to these lessons second hand, you get the benefits without having to pay extra for them directly.
Calculate the return on investment
A significant part of business valuation is calculating the return on investment (ROI). This is typically calculated by taking the net profit of the business and dividing it by its purchase price.
The numerator in this calculation is referred to as the equity value, and the denominator is referred to as the book value. Book value is simply the cost of the business less any outstanding loans or debt that could be retired with the proceeds from the sale.
By comparing these two numbers you can determine whether investing in your current company makes sense. If the ROI is high, then selling and buying another business may not be the best option. But if the ROI is low, then that might indicate there’s room for growth.
When determining the potential return on an investment, consider how much money you are willing to invest, what kind of returns you want to receive, and what type of business you feel confident owning.
Business owners often have strong feelings about their companies, which can influence their ROI calculations. Make sure to factor this out when performing due diligence.
Negotiate until you get a good deal
The hardest part about buying a business is actually negotiating the sale! Before you even consider making an offer, you have to know what price is justified. You can’t just make an offer willy-nilly without knowing how much your competitor owns their company and what they paid for it!
It sounds crazy, but this is very important. If you don’t understand market value, or how companies retain and grow equity, then you won’t be able to accurately gauge whether or not your offer is fair.
You need to factor in all of the money that has gone into owning and running the company – depreciation expenses, marketing costs, etc. Plus, you should include the worth of the company itself (the net asset value) as well as its underlying assets such as machinery and equipment.
The key thing to remember when calculating the price of a business is that you are trying to determine if the offering price is ‘fair’. What does that mean? It means that you must compare apples with apples — something that most people forget.
Take a financial snapshot of the business
The next step in evaluating the value of a business is taking a comprehensive look at its finances. This includes looking at both hard numbers such as revenue, expenses, net income, etc., and also assessing how well the company is running compared to similar companies in its area or industry.
When doing your due diligence, you want to make sure that you have considered all of the possible steps for the business to succeed, and that you’ve factored in any potential failures. You don’t want to overvalue the stock because you assumed too much success when there could be big changes ahead.
By having a full picture of what the company has been able to do so far, we can determine whether investing in the company makes sense now or if it would be better to pass and try another option.
Do you like the business?
What is the price of the business’s stock? Is it growing or shrinking? If it is shrinking, what will be the next most cost-effective way to cut costs? Are there better alternatives for its services that it can be replaced with?
If none of these questions have been answered, then why would someone pay money to purchase the business?
It seems irrational to buy something if you don’t know how much it is worth. You wouldn’t walk into a jewelry store and ask, “How much are all this stuff worth?” Before you make an investment, you should at least have an idea of how expensive it is.
The same goes for buying a business. You shouldn’t invest in a company unless you have some sense of its value.
Business owners often underestimate the value of their companies. This happens because they may not want to sell, or even recognize the signs that it is time to sell.
More than half of businesses remain under the ownership of the original founders for more than ten years (Baumgartner, 2012). These individuals usually retain control over the company, so they do not see the need to reduce the price.