You must be wondering - why do you need to know about the valuations. It is whole lot of financial mumbo-jumbo, and you want nothing of it. You would rather get a professional to do it, or even better, let the lending bank do all the valuation stuff.
But there is a slight catch here. If you don’t yourself evaluate the potential of the business you are about to buy, you are running a risk of paying up for an over-valued acquisition. You must find out whether the price offered is fair or not; whether valuation by the professional is as per your own estimates or not. Yes, the professional would do a fair job, but you would certainly want a second opinion, and who is better than yourself to consult with.
Moreover, you would want to impress the banker with your thoroughness: about the business you want to step in; about the process; about the accuracy of estimates, and give an impression that you are smart enough not to be taken for a ride.
Before we actually get to the number crunching part, you are advised to take following steps:
Visit the Facility:
Nothing like actually going through the facility and seeing it in action. Don’t go by the super numbers on paper, visit the business. In fact, get an appointment with the seller to check out the business and then go again by yourself. This is the best way to find out the ground realities.
Decide on Professional Help:
Seriously consider contacting someone to do the valuation. If you don't want to hire anyone for the evaluation, at least get an attorney for help on the sales contract. There are many legal issues involved in such deals and only a professional can ensure that you are not placed at any disadvantage by the seller.
Request financial information:
The minimum you must insist upon:
- Financial statements for three years.
- Corporate Tax returns for three years.
- List of capital assets
- List of equipment.
- Inventory listing
- Accounts receivable aging.
- Accounts payable aging.
Check out the price of comparable businesses and the industry: The professional you would hire might give you some information, but the best place is Internet. Check out the forums; articles; ask the industry experts.
Now let’s get to the actual valuation part.
The following ratios are some of the basic ratios to consider:
• Price to Sales
• Price to Earnings (net)
• Price to Cash Flow or Price to EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization)
• Price to Book
Typically following methods are used for valuation:
1. Adjusted Book Value: It is based on the assets and liabilities of the business.
2. Asset Valuation: It is based on inventory and improvements that have been made to the physical space used by the business. Discretionary cash from the adjusted income statement can also be included in the valuation.
3. Capitalization of Income Valuation: Places the greatest value on intangibles while giving no credit for physical assets.
4. Capitalized Earning Approach: Based on the rate of return in earnings that the investor expects.
5. Cash Flow Method: Based on how much of a loan one could get based on the cash flow of the business. The amount of the loan is the value of the business.
6. Cost to Create Approach (Leapfrog Start Up)
Used when the buyer wants to buy an already functioning business to save start up time and costs.
7. Discounted Cash Flow: Based on the assumption that a dollar received today is worth more than one received in the future. It discounts the business's projected earnings to adjust for real growth, inflation and risk.
You must get the professional to clearly explain the valuation method used and its justification. The reasoning behind the pricing is critical for evaluating the personal risk involved.
Apart from above described methods, there are some more methods of valuation which I will describe in my next article.
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