Question
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 inc.com 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.
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.
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.
