Discover more about this straightforward, common sense approach to help you value a business with the Income approach. Whether you are buying a business or selling a business, this simple explanation of the Income valuation approach will be helpful and will give you something to use as comparison when talking value with brokers or colleagues. Basic, rule-of-thumb lessons such as this one can’t consider all of the small details involved in determining an accurate business value, so don’t make a purchase or sale based only on this. Talk to your current business advisors about how cash flow and cap rate apply to your particular situation, or talk with Steve via email or phone to get his advice.
I promised you that I would give you a way to do a real rough valuation of a business using what we call the income approach. Now, business brokers and other have different rules of thumb that they use and those are valuable often times they get you into the ballpark of what a business might be worth. But I like to have a common sense approach, and it’s more than just common sense because there’s a lot of science to it and how we actually use it as certified valuation analysts. But, this is just a way for you to think about it. In the income approach there are two numbers that are really important and you see them right here. Cash flow, you can also use income but I like to use cash flow, cash flow and cap rate.
When you know those two numbers, you can determine an estimated value. For instance, if our cash flow was $100,000 a year and we wanted a 25% return on our money, a cap rate, 25% return on our money is the equivalent of a four times multiple. So 100,000 of cash flow times four is $400,000. That would be the amount I would be will to pay. Why? Because the $400,000 times a 25% rate of return would get me that $100,000 a year of cash flow that I need.
The trick is, though, what is cash flow? You can take the financial statements or tax returns on any business and you can begin to look and see what sort of cash the business generates each year. When we do valuations we often look at the last five years and we average them, either a straight average of the five years or we do a weighted average depending on how we think the market is changing. But just to keep it simple, let’s say it’s a straight average.
So you could add up the cash flow for each of those five years and then divide it by five and you’ll have your average cash flow to take and use with the cap rate. The trick though on cash flow is that you don’t just take the number off of the financial statements but you make some adjustments to it before you use it. You need to look and see what kind of expenses are in there. A lot of small business owners run a number of questionable expenses though their tax returns. Let’s say that you’re looking at a particular
business and in one of those years the owner purchased a boat to use at his cabin and he decided to put it on his tax return and call it an entertainment facility. Seen it done. You’d want to take that out because it’s not an ordinary and necessary expense of the business.
And that’s the test, Is it an ordinary and necessary expense of the business? So we try to clean that up. You might find people running fuel for their vehicles, for their personal vehicles through there, personal telephone expenses, fees to professionals for personal things that they run though their business. People are very creative in what they put in there. So you want to clean it up so that you understand what this cash flow is on a normalized basis, what would be normal and not necessarily what all did that business owner run though there. So once we’ve cleaned up that cash flow and we’ve got a number, then we need to move on to determine what the cap rate is. And, determining cap rate is a complicated process, and I said I would give you all a little bit of a rule of thumb here, so I’m going to give you some ranges of cap rates that you might consider.
If you want to get into the detail, I have some articles on my website that walk you through in a little more detail how to determine cap rate. But for our purposes here, I often find that a lot of small businesses sit without risk factors somewhere between 20% and 33%. The higher that percentage, if you said I want a 33% return on my investment, that means you think that particular business is more risky than a business that you would only require a 20% rate of return.
You’ll accept a lower rate of return when you believe there to be a lower risk. But most small businesses fall somewhere in that 20 to 33 percent range. And so a 20% rate of return is a five cap rate, a 25% rate of return is a four, and a 33% is a three. And so, once you have determined this cash flow, you could say the multiple that I would apply to that might be three, four, or five depending on how much a risk I think there is. Three, being there’s a lot of risk and five being there’s a lower risk.
Now that’s not perfect and I’m just trying to give you a way to think about it. Something to compare against that business broker’s rule of thumb that he might be using or that some of your friends are telling you. Just another way to look at it. If you find that in doing that numbers are quite a bit different, that might be an indication or a reason why you might want to go visit with a valuation analyst in your area and hire them to evaluate a particular business you’re looking to buy or sell to really hone in on what the rate really is. Rules of thumb and shortcuts like I just talked about are imperfect by their very nature, but I wanted you to just at least understand the basics of how you begin to determine value of a business using the income approach as we just discussed here.