Describing a small business: A small business basically has 3 main parts namely Business, Customer, Owner. On the other hand, in case of a large business we have owners in the form of shareholders and other two parts customer and business is pretty much same.
Now we will understand how the cash flow happens in a small business and how can we value it.
Let us take a example of a ice cream shop which is owned by a person let say Mr. X, now he has 1 employee working in the shop who takes care of each and every thing in the shop. So let us assume that the business generates a revenue of Rs.100 per hour through sales. So now we will see how these Rs.100. flow in our business. Out of these Rs.100, Rs.20 is the salary of employee and Rs.40 is the cost of the ice cream which was sold in that hour and Rs.10 is the rent of the shop (calculated on per hour basis) so now these all expenses add up to Rs.70. Rs.70 Will be the cost of selling goods and the remaining Rs.30 is remaining and from that Rs.30, owner will pay Rs.10 as tax and at the end he will remain with Rs.20 and this is the net profit or earnings for the owner.
So valuation of a business completely depends upon how much you are willing to pay for that business, so if we say that the net profit for ice cream business is Rs.20,000 for the whole year. So valuation is basically how much is the business worth.
Now lets say we have three different opinions on the valuation:
1. Rs. 400,000, which will give an annual return of 5%
2. Rs. 200,000 which will give an annual return of 10%
3. Rs. 100,000 which will give an annual return of 20%
On observing these options each option is giving different types of return on your investment as option 1 is 20 times the net earnings and option 3 is 5 times the net earnings. And the important point to note is our business never changed but the valuation is different in all the 3 options and accordingly the return on investment changes.