: tools & methods for small businesses

Rules-of-thumb have the nasty habit of being used for so long that we start to think they’re more than rough guides, that they are, indeed, shortcuts to avoiding real work. And so it is with a whole lot of ‘back of the envelope’ approaches to figuring out how much a business is worth.

With this bit of foot shuffling, the fastest way to get a v-e-r-y rough business evaluation is by way of ‘multiples.’

We’ve gotten used to hearing about multiples in stock market reports: such and such a stock is running at 20-times earnings. Investment real estate is another place where multiples get a lot of press: the rule of thumb being commercial real estate sells for about 8-to-10 times the amount of income it generates.

There’s a great article by Glen Cooper in BizBuySell about Valuation Rules of Thumb. (anything I get right here is because of his article, anything wrong – mine entirely). http://www.bizbuysell.com/guide/b_value_1.htm

OK, I promised 30 seconds. Here it is.
1. You need to conjure up what you think NEXT year’s earnings from the business will be. These are real earnings – not the smallest possible number that the IRS encourages us to send in every year — earnings without those padded expense accounts, those magazine subscriptions, those business junkets to Must-Attend industry conferences (in Maui, in February…). In the jargon, projected ‘normalized earnings.’

2. Take this dollar amount .. AND MULTIPLY IT BY 3 or 4 or 5. That’s it!

I’ll spare you the obligatory shuck-and-jive about how this is only a very, very crude approach – but do take all these guides with a grain of salt and a little chuckle. That said, it is a frequently used rule of thumb. And it starts to give you an idea about valuation.

Why a 3-to-5 multiple?
-Well, if you buy a company for 3-times its earnings, it’s gonna take you 3 years of ownership til you get your money back. And – very very simplistically – after that, ‘the money is *yours*’. In numbers – your return-on-investment is 33%.
-If the multiple is 5 – you’ll wait 5 years to get your money back — an annual ROI of 20%.

Now – a 20% return on any investment is pretty darned good. 33% even better. The point is, the appeal of this kind of return makes a company being sold a very tempting offer.

And anyway, it’s also a cool way to spend 30 seconds …