Valuing a business in the context of a takeover is both an art and a science. Paying too much leaves no room for error, especially if you’ve used the debt to fund the buyout. There are different methods of evaluation. The simplest is a top-down approach that applies a multiple to the gross revenue or sales of the target business to get a valuation. However, relying on a single valuation method to buy a business is risky. Use alternative valuation methods that support the use of gross income as the basis for a business buyout.
Collect the financial statements of the target company over several years. You want a good historical representation of the company’s profits, especially its gross income, since this is the number you want to use as the basis for a buyout amount. At a minimum, you should have five years of financial data, but the more historical information you have the better.
Use several years of historical income statement information to reconstruct a basis for using gross income as the valuation method for the buyback. Ideally, gross income should be stable and growing. Large fluctuations in gross income suggest an uneven income flow, making it more difficult to predict future income. For example, calculating an average gross income over 10 years is more meaningful and a more accurate representation than an average taken over three years.
Identify trends in gross income, such as the seasonality of earnings. If this is the case, you should take this into account when determining a redemption amount.
Match the gross sales receipts with the gross income reported in the company’s financial statements and tax returns. This involves going through the company’s invoices, ledgers, cash flow, and bank statements. The process is easier if the target business maintains accurate accounting and bookkeeping.
Meet with the company’s accountant to discuss the preparation of the financial statements. You should also ask your accountant to review the financial statements in a meeting with all parties to the transactions. This is your opportunity to ask management tough questions about the sustainability of its earnings, future prospects, business opportunities and threats.
Apply a gross income discount for outliers to get an average gross income over a significant period. You must apply a discount to years with unusually high gross income. It is important to be careful with your gross income assumptions. Other reasons for applying a discount are if the business derives a large portion of its gross revenue from a large customer, potential customer defection, or key personnel defection. You should also apply a discount if there is seasonality in the gross income.
Look for companies of similar size to develop a peer group for comparison. It is important that you develop a composite profile of the companies in the market to determine if the company is increasing its sales at the same rate, below or above the average relative to the competition. Your research should also include current buyout prices for similar sized businesses. This process is difficult if the companies in the market are private.
Apply a multiple to the average gross revenue of the target business based on the prevailing buyout rate. Use buyout rates for publicly traded companies in the same industry if you’re having trouble getting direct comparisons with peers. If the companies in the market are selling for a multiple of 1.5 to 2 times the gross income, use a reasonable multiple within that range to calculate a buyout amount for the target company. For example, the buyout price of a business is $ 776,900 for a business with an average gross income of $ 457,000 and a multiple of 1.7.
- Buying a business involves a lot of due diligence, including talking to the target business’s management, suppliers, and customers. You are on a fact-finding mission to understand the ins and outs of the business in order to make an informed purchasing decision. Additionally, use various valuation methods to corroborate and support your purchase price. Some other valuation methods include discounted cash flows, the asset accumulation method, and market value.