What are the various methods to evaluate a company that’s for sale? And basically the strategy that people use when evaluating a company fall under certainly one of three camps. Let’s have a look. So our types of small company fall under three different camps or schools of thought. The very first one being market comparison. If you wanted to have a business evaluated as a consumer or perhaps a seller and you visited someone who had the proper training skills and access to information on the best way to evaluate a tiny business.
One of many things they would actually do is really comparing the topic company that you’re considering with other businesses in the exact same industry that have already sold. And what they would like to do is compare similar businesses and similar size businesses. And what they are going to find is what other folks have paid as a percentage of sales and as a factor of discretionary cash flow Therefore the database might come back and tell me that a given company might sell for; other folks paid about 32% of sales like, or they paid times discretionary cash flow.
So we’re actually comparing the topic company with other businesses that have sold. And what we’re doing is that people are now obtaining the feedback of most those previous buyers and more listening with their opinion of what they thought the risks were in engaging in this industry. To ensure that undoubtedly in my experience is one of the finest way to evaluate a business. The second group may be the capitalization or I put mathematical methodologies. Because basically what we’re doing in cases like this is we want to figure out what rate of return will make us happy. What do you want to see happen by the end of the afternoon when we were to own this business? Are we planning to require a 20% return on our investment? Are we planning to require a 40% return on our equity that people put into the deal? So there are lots of other ways that you could look at it from the mathematical point of view.
And if we’re buying certain percentage, these are often called capitalization rates. Cap rates are utilized quite often like in the actual estate evaluation area. The other way to look at it is multipliers which is a similar thing, just from a different point of view. So you may hear people say that certain businesses sell for 3 x earnings for example. That might be an example of a mathematical or capitalization type way of business evaluation. The third category is likely to be simply considering the assets involved. So I call it asset evaluation or cost to create, where you are going to check out, what are the various tools, equipment, inventories, receivables, operating capital etc. required to create this business function. If I were planning to have a subject company and recreate a similar thing nearby, what can it cost me? Now part of the can be achieved from the balance sheet of the organization, but to really get it done accurately you would have to judge and uncover what the marketplace value was of certain assets within the business: hiring appraisers, evaluators, this kind of thing.
So the one thing though this band of methodologies doesn’t include or leaves out is goodwill. So if we have a profitable business that produces money constantly, then it’s conceivable that there will be a goodwill element of 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. You can find 13 specific methodologies that I personally use when I’m doing an evaluation. And I don’t employ all of them in most case. But I try to own one or more from each one of these three groups. It may be informative like when you’re creating your deal structure that you could offer an sum of money that included goodwill. So your offer could be centered on a market evaluation or perhaps a capitalization method, but perhaps you don’t want your down payment total be greater compared to asset or cost to create.
So that the amount that you’re asking the vendor to finance, the vendor gets back is in fact largely the goodwill component, which makes it safer for you and makes financing more easily. Have a good day.