How to evaluate a business

There are a number of different ways to evaluate a business's value.

Here's how I simply evaluate them. There's only one question that matters: Can you make a reasonable return on your investment given the amount of profit left over at the end of the year?

I define reasonable as 20-25%.

A typical rule of thumb that I like to use is 3 - 5 times EBITDA. EBITDA is an accounting term that stands for "Earnings Before Interest Taxes Depreciation and Amortization". To calculate it, you take the profit before taxes and add back in any interest, depreciation and amortization. Multiply that number by 3 and 5 and you have the low and high ranges of the business value.

If you can't calculate a business on profit because there isn't any, it doesn't mean the company is worthless.

If the business has real assets like inventory or equipment, the value can be determined at a percentage of the depreciated asset value on the balance sheet.

For instance, a restaurant that has no profit may have equipment worth $200,000 for sale. There is obviously value in the equipment. The question of how much value is dependant on the motivation of the seller and the willingness of the buyer. 

I recently talked to a business owner who had profits of $100,000 but wanted $800,000 for his business. At 8 times EBITDA, I immediately wanted to look at the balance sheet. The balance sheet had assets valued at $320,000. 

The value of his business is worth $300,000 to $400,000 to me.

Unfortunately, it is worth twice that to him.

A motivated buyer who overpays for a business is going to have below average returns on his investment. The buyer also jeopardizes the viability of the business when he overpays. The financial commitment might be too high for any return. Securing bank financing will almost be impossible. 

When a business is worth more to the seller than it is to the buyer, a deal is hard to do.

For any deal to happen, you need both a willing buyer and a motivated seller.

If the seller isn't motivated, then a reasonable deal will be as difficult as pulling your own teeth with a set of pliers without a shot of whisky.

Evaluate the motivation of the seller before talking price. Don't waste your time with someone who is looking for a 100% premium above the EBITDA value or the depreciated asset value. Make an initial reasonable offer. If the seller doesn't respond positively, walk away.

There can be no deal if the seller's expectation is unreasonable.