Q: A friend is urging me to buy her laundry business along España in Quezon City, but I don’t really know how to evaluate whether the price she gave me is fair. How do I know if the price is right?
A: There are many ways to value a business. One is to value the business based on investments and profits made to date. Also known as book value, this method simply prices the business based on historical cost. The selling price shall be based on all the assets, including bank account and receivables, minus outstanding payables and loans, if any. This is the minimum price you can expect as it simply returns to the owners all the money they put into the business plus all the profits not withdrawn in the past. The closer the selling price is to the book value, the better the deal is.
Another way to value a business entails pricing with a premium. The price is usually higher than book value because it takes into account the earning power of the business in the years to come, thus the need for premium.
To incorporate premium into the price, you can either use price-to-book value ratio or price-to-earnings ratio. You can price the business based on multiples of book value or earnings. You can apply market multiples available for your specific industry, say price-to-book value of 3x or price-to-earnings ratio of 10x to get the estimated fair value. If the selling price is higher than fair value, then it’s expensive. If it’s lower than fair value, it’s considered attractive and worth evaluating further.
When you evaluate, you need to validate your estimated fair value with the business financials. Ask your friend for the historical financial statements of the business for the last three years. Find out if the business has been growing over the years and how much on average. Make sure there is enough room for revenue growth once you take over the business. The bigger the growth prospects, the more attractive the business is.
If revenue has been declining, it might mean problems for you in the future. However, if you think that you can manage it better, you can use the current business situation to negotiate for a lower selling price.
Review how consistent the growth in net income is. It should be stable and predictable. You also need to determine the net profit margin. If profit growth is not aligned with revenues and net profit margin is not stable, managing costs may be a problem.
Check if there’s room to improve the cost structure of the business. Maybe you can cut costs to enhance your net profit margin. The higher the potential increase in net profit, the higher the valuation the business will have in the long term.
If you do decide to buy the business, make sure that you have a business plan for the next three years. This will help you budget your expenditures and expenses. It also serves as a road map on how to recover your investment in the business and grow it in the long term.
Henry Ong, CMC, CMA, is president and COO of Business Sense, a business advisory firm that provides expert solutions to small- and medium-sized companies. You may reach him at firstname.lastname@example.org or follow him on Twitter @henryong888.
Photo: Getty Images
This article was originally published in the March 2014 issue of Entrepreneur magazine.
Subscribe to the print or digital version of the magazine here.