Who Else Wants To Know The Secret Of A Buyers Business Valuation?
How does a buyers business valuation differ from any other valuation? And does it really? That really isn't a fair question since you already have the unfair advantage of having been told that there is a difference. And that buyers have a unique perspective. So let's get at it.
What is that perspective that is unique to buyers? It is one of those things that sounds simple. And it is simple. You as a buyer need to take as much risk out of buying a business as possible. You need to be able to predict the return that you will make on your capital, with the greatest confidence possible. And that the return that you can earn will be satisfactory. A buyers business valuation is a tool you can use to validate this.
So far so good. But what does that really mean? One thing it means is that you need to be aware of where the business is in the overall business cycle, and in the business cycle for its industry. In the latter case, there may or may not be a unique industry cycle. Using the business cycle is part of your buyers business valuation. If you are trying to understand these statements, let's remember something that Warren Buffett said. Effectively he said that an investor will pay a high price for a cheery consensus. The implied message in this is that when everybody is optimistic about something in the economy, that's when it likely to be at its peak. And when it will be most costly.
So bringing that back to your own situation. Is the business really doing well? In fact, is all business doing really well? That is one sign. So if the economy is doing really well, that generally reflects an easy money policy by the Central Bank. It means that money is easy to borrow, and it is cheap. Meaning interest rates are low. This has stimulated borrowing and massive consumer buying. If interest rates are really low, what other way can they go but up. And that is what usually happens that signals an end to a business cycle. There are other considerations also, like consumer demand being almost completely satisfied. So demand begins to soften. And consumer credit cards being maxed out. So they run out of buying power.
When this happens the effect is felt by most businesses. And it is likely going to be felt by the business you are considering buying. That doesn't necessarily mean that you shouldn't buy the business you are examining. It does mean that you should be very careful about what you pay for it. You need to examine the valuation very carefully. Because two things are likely to happen at the end of a business cycle. Demand for the product or service will shrink. And, interest rates are likely going to increase.
Let's analyze the valuation on the business. It may be a formal document prepared by an experienced professional. It may also be a quickie valuation based on a multiple of cash flow. Regardless of how it was prepared, you need to identify the underlying assumptions. Understanding and validating assumptions is a big pert of preparing your buyers business valuation. What explicit or implicit assumption does it make about interest rates, and the direction that they are likely heading. If the underlying assumption is that interest rates will likely remain constant, does this make sense based on external economic conditions? And if interest rates should increase, what will that do to the annual cash flow from the business, assuming other conditions remain constant? If you haven't the expertise to recast any pro forma financial statements, adjusting for different future interest rates, you should have it done by someone knowledgeable.
What will happen to cash flow or earnings when demand softens? It is likely that the impact will be in two different but related areas. One will be a reduction in the overall volume of business. The other will be a reduction in margins. The combined effect on the business you are evaluating could be quite significant. The overall gross profit could be considerably reduced, or disappear completely. When combined with the impact of your different interest rate assumptions, the impact on overall cash flow or earnings could be devastating.
What will the result of this combination of circumstances do to the return on capital that you can earn from the business? Remember, that must be your ultimate goal. You will be providing capital to buy the business, and you will need to earn a satisfactory return from it. The other key consideration here is that there are two parts to the return calculation. One part is annual cash flow or earnings after needed adjustments for more likely future interest rates and business volume. The other part is the price of the business. (Terms can also play a role, but let's ignore them to keep it simple.)
In concept, if the return you get by dividing adjusted cash flow by asking price is inadequate, what can you do about asking price? At what maximum asking price can you expect to earn an adequate return on capital? Is there any reason that you can't explore a lower price with the current owner? The worst he can say is no. Will this work with all owners? Not a chance. Some will have become so attached to a particular price that they would rather not sell than reduce the price. However some will have become tired of running their businesses. And tired of running hard to stay in one place because of where the economy is in the business cycle. These owners may well consider lower offers.
The purpose of this section is to convince you that any valuation represents a snapshot in time, but makes critical assumptions about the future. You need to understand those assumptions, and evaluate them in the context of the business cycle, and your belief in how the future will unfold. Then you need to evaluate the resulting asking price in this same context, to determine whether you can earn an adequate return on your invested capital. That is the primary purpose of your buyers business valuation.
I will tell you from bitter experience of a horrible trap you can fall into. You can decide that you really like and understand the business, and you can make it perform at a higher level than its current owner. For that reason you can rationalize the asking price despite your assumptions about future events. You will experience confidence in your ability to create the additional cash flow to more than cover the purchase price. We all tend to think that way. But it is foolish. It rarely happens. And if you follow that reasoning you will end up buying something that will never provide you with an adequate return on your capital. Unless you are very careful about how you structure the transaction. Don't try to be cute. Stick to the strategy that will follow from your buyers business valuation.
Now the mirror image of this can also be true. Businesses are bought and sold at all points within a business cycle. Some at the top, and some at the bottom. We have already discussed what happens at the top. At the bottom, the reverse will happen. Interest rates will be tending down. Business activity will increase leading to higher volume and cash flow. And with increased demand, at least until capacity can be increased, margins will tend to grow. This future may not be built into the valuation that is the basis for the asking price. The owner and all concerned may have become discouraged by a couple of years of really bad business conditions. So the valuation has been mostly predicated on those couple of really bad years. Really sophisticated investors say they buy when everyone else wants to sell. Thereby locking in a superior return. Their perspective is one worth careful consideration when you evaluate a business with the intention of buying.
To help you really understand all this and how it applies to your buyers business valuation, you may need to get a better understanding of the business cycle. There are lots of good sources for this. And by all means take the time to consult one or more. For one that explains it fairly concisely, please click on
, as a starting point.
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