We at Kapso Business Services, India’s Leading Business Brokers provide business owners what they need and guide them through the entire process. To buy a business to expand thier current one or sell a business to pursue other ventures, Business brokers and other have different rules of thumb that they employe to value a business and get the best value in the market for their client and those are valuable often times they get you into the ballpark of what a business might be worth. But we need 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, as put in layman terms.
In the income approach there are two numbers that are really important and we see them right here.
Cash flow, (we can also use income but cash flow is more widely used) and cap rate. When we know those two numbers, we 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 we would be able to pay. Because the $400,000 times a 25% rate of return would get us that $100,000 a year of cash flow that we need.
What is cash flow?
We can take the financial statements or tax returns on any business and 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 we could add up the cash flow for each of those five years and then divide it by five and we will have your average cash flow to take and use with the cap rate. The trick though on cash flow is that we don't just take the number off of the financial statements but make some adjustments to it before using it.
We need to look and see what kind of expenses are there. A lot of small business owners run a number of questionable expenses though their tax returns. Let's say that We are 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. When we see it done, we would want to take that out because it's not an ordinary and necessary expense of the business. We 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 we would want to clean it up so that the cash flow is on a normalized basis.
What would be normal and not necessarily what all did that business owner run though there?
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. We often find that a lot of small businesses sit without risk factors somewhere between 20% and 33%. The higher that percentage, if we said that we want a 33% return on my investment, that means we think that particular business is riskier than a business that we would only require a 20% rate of return. We will accept a lower rate of return when we 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 we have determined this cash flow, we could say the multiple that we would apply to that might be three, four, or five depending on how much a risk we think there is. Three, being there's a lot of risk and five being there's a lower risk.