Difference Between Net Income And Cash Flow From Operating Activities Pricing Your Business

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Pricing Your Business

Are you managing your business to maximize its value?

If you are thinking about selling or transferring your company, you need to have your own idea of ​​the value of your company. This essentially means that you view your company as an unbiased investor or customer instead of an emotionally committed owner.

The first step is to package your business for sale. Packaging your business for sale helps you make it a better business that is more valuable to a future owner and is also easier for you to manage until the transition occurs.

When determining the value of your business, some basic principles apply:

1. The value to the owner is unique to that individual. Ego can artificially inflate the price, but more importantly the role and relationships established by the owner can change drastically with his departure and thus affect the price.

2. Value is always determined by estimating future income relative to the uncertainty or risks associated with obtaining expected returns. Regardless of the valuation method (P/E multiple, payback period, or discounted cash flow), the projected future income stream must be solid and known risks must be mitigated to obtain the best possible valuation.

3. Current owners tolerate more risk, uncertainty and “unclear” circumstances than new owners/investors. You may be okay with the fact that you depend on one key supplier because he’s an old friend from high school; or that you do not have a signed rental agreement, but the landlord is your uncle; or that your best sales representative is also your only son and he wants to be president. Prospective buyers will be much less enthusiastic unless all of these issues are resolved to their satisfaction prior to any offer to purchase or invest.

4. Different customers will accept different prices, terms and conditions. They usually range from a passive investor looking for a reasonable return with a reasonable risk; to an active investor who sees the potential to do better than your forecast under his own management; to a strategic investor who sees an even greater opportunity in buying a competitor, supplier or customer and merging it with their existing business to increase revenues, eliminate unnecessary overheads and significantly increase profits. The sales price will increase accordingly.

Several valuation methodologies can be used and it is often a good idea to test different approaches to see what values ​​they yield and then select a “market” price that can be reasonably supported by any valuation method.

P/E multiple

The price/earnings multiple is a well-known valuation method and is widely used for public companies. The current price divided by the last reported annual earnings per share is a simple concept and a simple calculation. Unfortunately, it’s usually not very relevant since today’s price is based on expected future earnings, not last year’s.

For example, Google’s price today (December 10, 2007) of $718 gives a P/E multiple of 56x based on current earnings of $12.78 per share. But if we use the current analyst consensus of $19.51 for the next 12 months, the P/E is a more “reasonable” 36.8x. Still high compared to its main competitor, Microsoft, at 22x.

What is the P/E multiple for your company? Typically small owner-managed companies can support a P/E multiple of around 5x. It can be higher if earnings are very secure and not dependent on the current owner/management, and lower if future earnings are risky and highly dependent on the current relationship with the owner. A buyer will typically look at operating income or EBITDA (earnings before interest, taxes, depreciation and amortization) to determine profitability before financing, taxes and capex. This means an equity value of $500,000 based on your annual operating income of $100,000 if you accept a 5x P/E multiple.

Return period

Some buyers will insist on looking only at net cash flow and payback periods to arrive at an acceptable price based on expected earnings. They will look at their net investment, after taking into account financing, taxes, incentives and payment terms to determine how long before they recoup their investment and start earning positive cash flow. It is likely to have a minimum payback period, depending on the risk, of 3 to 5 years.

Discounted cash flow

Other investors will take a pure financial approach of calculating discounted net present value (NPV) or return on investment (ROI). Again, future net cash flows will be projected to arrive at the estimate. The buyer will then discount their required rate of return, typically 15% to 20%, or calculate the expected ROI compared to that required rate of return.

Using the same methods will give you a range of estimates depending on different forecasting scenarios to establish your own best estimate of fair market value.

For more ideas on how to get maximum value for your business, contact us or visit Business Solutions from DirectTech at http://www.directtech.ca.

Del Chatterson © 2007

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