Do you want to buy or sell a business but don’t know how to determine its true value? If YES, here are 20 tips to help you value a business based on revenue.
Business valuation is one of the most important aspects of a business buy/sell agreement. You want to ensure that you don’t pay more than the business is worth to assume ownership, and at the same time, the seller wants to ensure that they get a fair price for their business. Both parties would have to find a common ground, and this is not always a walk in the park.
There are no hard and fast rules for valuing a business, however there are a couple of business valuation methods commonly used. A business can be valued based on its book value, the assets the business currently owns, and the revenue it generates.
The revenue based approach is a very good one because you are able to have a clear idea of the economic benefits that you will derive from your investments in the business. Since the major reason for buying into a business is for you to make profit, this is a very good method to help determine if you will be able to achieve this goal.
Also, if the seller is trying to sell the business because it is no longer profitable, this valuation method would help to reveal this so that you can avoid buying a failing business. As a seller, this method of business valuation is very good for you because you are able to charge a fair compensation for all the efforts you have put into marketing, promoting and building a good relationship with your customers.
Here are 20 tips to help you get your business valuation right when using the revenue based method.
20 Tips on How to Value a Business to Buy or Sell Based on Revenue
1. Consider the Business Industry: The first thing you should do is to understand the industry in which the business operates. This is important because revenue and profits in different industries are not valued equally.
For instance, revenue of $50,000 per year in a medical practice is valued higher than $50,000 revenue in a restaurant business because a medical practice has more long-term stability and success rate than the highly competitive restaurant business.
2. Understand That Revenue Isn’t Always Profit: A business can earn a lot of revenue but that doesn’t necessarily translate to profit. Some businesses earn a lot of revenue but they still have to reinvest those revenues to keep the business afloat and buying such businesses will not make you profit.
3. Use Past History to Forecast Future Earning: You can use the previous earnings of a business to determine what it is likely to earn in the future. You can consider the earnings of the company for the past five years to give you an idea of the average revenue that the company would make in the future.
4. Understand That Earnings are Not Always Stable: There are a number of factors that may affect revenue including competitor activities, decline in the industry, and changes in supplier prices. It is important to factor these in when you are making your revenue projections.
5. Use Discounted Cash Flow Analysis Method: This method was made popular by Warren Buffet. What he did was to consider the cash generated by the business yearly, use it to make future projections, and then calculate what that cash flow stream is worth by using long-term Treasury bill interest rates. A simple way to do this is to divide the total earnings of each year by the current long-term treasury bills rate.
So if the long-term Treasury bill rates are currently at 2.5% and the business makes $10,000 annually, it means the business is worth $400,000 worth of treasury bills ($10,000/2.5%) because if you invested $400,000 in treasury bills, it would give you $10,000 returns annually. So it’s safe to say that the business is worth $400,000 or a little less than that if you consider some other non-financial factors.
6. Find out What Similar Businesses are Worth: Another helpful technique is to find out what similar businesses in that industry and location are worth. You can take a look at their financial statements, level of patronage and revenue. Except there is something uniquely different about the business you are trying to value, there is a huge chance that its value would be only slightly different from the other businesses.
7. Use Profit Multiplier Method: You can also use the industry-based multiplier method based annual profits to determine the value of the business. You will have to find out what the multiplier for that specific industry is, and multiply the company’s annual profit by that number to determine the value of the business. For instance, the multiplier for the food service industry is 2, while that of a retail storefront is between 0.75 and 1.5.
8. Consider Value-Detracting Variables: The fact that a company is earning a lot of profit doesn’t necessarily make it a highly valuable business. You have to consider value-detracting variables too. For instance, if the business is earning a lot of revenue in a particular location, but the business is about to lose its lease which means that it might have to relocate to another place when you have bought the business, the current revenue of the business cannot be relied upon because it is possible that there would be changes after relocation.
9. Account for Operating Costs and Expenses: Compare the income of the business to its operating costs and expenses. No matter how much a business earns as revenue, if the cost of operation are too high, it may swallow up the profits of the business.
10. Estimate the Cash Flow of the Business: Understand how money flows through the business as well. The business can only stay afloat if there is always enough cash to run it. You can use a method known as the Seller’s Discretionary Cash Flow model to measure the earnings of the business.
11. Factor in Credit Financing: A seller that is willing to offer financing to the buyer is certain to value their business higher than a seller who is charging cash.
12. Use Online Calculators: To take off the stress from you, you can simply use an online calculator to determine the value of your business. CalcMXL and EquityNet are very commonly used calculators for business valuation.
13. Consider Tax Advantages: As a seller, if your business enjoys any tax advantages that will potentially increase the net revenue of the business, you can also factor this in when determining the value of your business.
14. Consider Contracts: Sometimes, the revenue of a business may be tied to some contracts and agreements that the business enjoys such as non-compete contracts, employment contracts, or leases. If these contracts are not transferable to the new owner of the business, then the business revenue may not stay the same upon purchase hence it helps to consider these factors when you are trying to come up with the value of a business based on the revenue it earns.
15. Hire an Expert: If you can afford it, it helps to hire the services of a business valuation expert. These are professionals trained to look beyond the surface when determining the value of a business and using their services can help you avoid a lot of potential problems in the future.
16. Consider Financial Leverage: You should also consider the post-acquisition financial leverage of the business. If a business has a low financial leverage due to its low asset base, it will typically be valued at a lower price even if it earns higher revenue than a business with high asset base and a higher financial leverage.
17. Industry Standard Performance: The business might be earning a lot of revenue but this revenue may still be low when compared with the industry standard. It helps to look at what other businesses in the industry are earning before coming to a conclusion on the financial performance of the business.
18. Consider Government Regulations: Are there any government regulations or policies now or in the future that may affect the revenues of the business in the future?
19. Find out the Seller’s Motives: Since no businessman is ever willing to let go of a well performing business with a healthy revenue stream, it helps to find out the exact reasons the seller has for deciding to sell the business; you may be able to discover some hidden factors behind the sale.
20. Consider Client Base: Lastly, you should also consider the clientele of the business. If a business is doing well, and earning a lot of revenue but has only one or two good customer’s, it means that a loss of any of these customers might affect the profitability of the business.