In our mission to advise, inform and inspire business owners and managers we offer these ideas for your consideration. 

Pricing your Business 

Are you managing your business to maximize its value?

If you are considering sale or transfer of your business you need to have established your own idea of the value of your business.  It essentially means looking at your business as a dispassionate investor or buyer instead of the emotionally committed owner. 

The first step is to package your business for sale.  See our recommendations on that process.  Packaging your business for sale helps you to make it a better business that is more valuable to a future owner and also easier for you to manage until transition occurs.

In establishing the value of your business, some basic principles apply:

1. The value to the owner is unique to that individual. Ego may artificially inflate the price, but more importantly the role and relationships established by the owner may change drastically with his/her departure and thereby affect the price
2. Value is always determined by an evaluation of the future income relative to the uncertainty or risks associated with obtaining the expected returns. Regardless of the valuation method, (P/E multiple, payback period, or discounted cash flow) the forecast future income stream has to be solid and the known risks have to be reduced to get the best possible valuation.
3. Current owners tolerate more risk, uncertainty and "fuzzy" circumstances than new owners/investors. You may be OK with the fact that you are dependent on one key supplier because he is an old high school buddy; or that you have no signed lease but the landlord is your uncle; or that your best sales rep is also your only son and he wants to be president. Prospective buyers will be much less enthusiastic unless those issues are all resolved to their satisfaction in advance of any offer to purchase or invest.
4. Different buyers will accept different prices, terms and conditions. They  usually range from the passive investor looking for a reasonable return with  reasonable risk; to the active investor who sees the potential to do better than your forecast under his own management; to the strategic investor who sees even greater opportunity in buying a competitor, supplier or customer and merging it with his existing business to increase revenues, eliminate unnecessary overheads, and substantially increase profits. The selling price will increase accordingly.

Several valuation methodologies may be used and it is often a good idea to test different approaches to see what values they yield and then select a "market" price that can be reasonably supported by any method of valuation.

P/E multiple

The price/earnings multiple is a well recognized valuation method and widely reported for public companies. Current price divided by last reported annual earnings per share is a simple concept and a simple calculation.  Unfortunately, it is not usually very relevant since the price today is based on the expectation of future earnings, not last year's.

For example, Google's price today (Dec.10,2007) of $718 yields a P/E multiple of 56x based on current earnings of $12.78 per share.  But if we use the current analysts' consensus of $19.51 for the next 12 months the P/E is a more "reasonable" 36.8x.  Still high compared to the slow and steady Royal Bank of Canada with a P/E multiple of 12.3x.

What is the P/E multiple for your company? Typically, small owner-managed businesses can support a P/E multiple of about 5x. Higher if earnings are very secure and not dependent on the current owner/management team and lower if future earnings are risky and very dependent on current relationships with the owner.  The buyer will usually look at operating income or EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) to determine profitability before financing, taxes and capital costs.  That means a price of $500,000 on your $100,000 per year operating income if you can agree on a 5x P/E multiple.           

Payback period

Some buyers will insist on looking only at net cash flow and payback period to arrive at a price. They will consider their net investment, after allowing for financing, taxes, incentives and payment terms to determine how long before they get their investment back and start earning positive cash flow.  They will likely have a minimum payback period, depending on risk, of from 3 to 5 years.    

Discounted cash flow

Other investors will take the pure financial approach of calculating discounted net present value (NPV) or the Return on Investment (ROI). Again the future net cash flows will be forecast to arrive at a valuation. The buyer will then discount at his required rate of return, typically 15% to 20%, or calculate the expected ROI compared to that required rate of return.

Using these same methods will give you a range of valuations depending on the various forecast scenarios to establish your own best estimate of fair market value.   

For more ideas on how we might help you get the maximum value for your business, contact us or visit Business Solutions from DirectTech.

Del Chatterson

© 2007

For creative, practical solutions that apply to the specifics of your business, please call us at DirectTech Solutions.

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