Small businesses are typically valued using one of two methods.
- A multiple of cash flow
- The value of the assets
Whichever is higher determines the method used.
Except when there is real estate involved these two methods are rarely combined. The theory is that a company’s assets are the tools it uses to generate cash flow. If the cash flow generated by the assets is low, the operational viability of the company or need for the asset comes into question. Unsuccessful advertising programs, dormant machinery or a fancy office that clients don’t visit are some of these. A buyer will look at these and figure that if the seller could not use these items to generate cash flow, how could they.
Look at the stock market for an example. When discussing the value of a stock, the universal point of reference is the Price to Earnings Ratio (P/E). Apple, for instance, currently trades at a P/E multiple of 15 times earnings and Google at a multiple of 33 times earnings. Both companies have billions in assets, but these are considered “built in” to the price. If the value of the assets were determined to be much greater than the price of the stock, the “break up” value would be favorable, and somebody may buy the company simply to see off the assets.
When approaching the sale of a business, the potential seller should carefully examine the necessity of each asset and liquidate those which are not essential to the operation. This is the best way to get the maximum amount for your business. This enables you to get the cash value for assets that will not be included in the cash flow valuation method.
It’s very difficult to get buyers to pay for potential.