Small business investors have to be able to value businesses themselves, since comparables usually do not exist.
Most people have come across classified listing sites like Businesses for Sale or Daltons (or BizBuySell in the US), when searching for a business for sale. Whether the listings are placed by brokers or the owners themselves, they share one thing in common: they are advertisements, and naturally will be trying to paint the business in the best light.
Other marketplaces, like the ones for homes and cars, have sufficient liquidity that market value can usually be determined within a fairly accurate range by simply comparing the prices of similar listings. One Toyota Prius is, after all, much like another. By filtering by age, mileage and features on Autotrader, one can get a very good idea of what the appropriate market price should be for a specific car.
Small business marketplaces are not like this – each business is so unique that there are usually no close “comparables” like with real estate and cars*. Many of the listings will not have an asking price, and the ones that do might not bear any relation to reality. Brokers very often over-price businesses, while owners who write their own listings might also have unrealistic price expectations. On the other hand, some businesses change hands for less than they are worth, representing a bargain for the buyer.
So how do you as an investor tell the difference between an over-priced business and a bargain? With no comparables available, you must be able to make your own judgement about what should be an appropriate valuation. There is literally nothing else to use for guidance in most cases, short of hiring expert help.
This is why small business valuation skills are so important. If you can weigh up the factors that will affect how much a business is worth on your own, you will be able to scan and filter opportunities much more quickly than if you had to ask advice for each one. With your own system in place for evaluating businesses, you can quickly determine your level of interest in each one and make a judgement as to its potential as an investment. Being able to attribute an initial valuation to each business is a critical part of this.
This principle is true regardless of where you find a business for sale. Besides the classified listing sites, you might come across an opportunity via word of mouth in your own network, from a customer or supplier, from an insolvency practitioner, or even from Facebook. In every case, you still have to be able to gauge the initial attractiveness of the opportunity yourself, before deciding whether to investigate the opportunity further.
Most investors have to scour hundreds of opportunities before finding the right business. This takes time, and anything that can be done to accelerate this process is valuable. No one has the time (or money) to ask their accountant and lawyer about every single opportunity they come across, just as no one would ask their mechanic to take every car on Autotrader out for a test drive. The initial evaluation must be done by the investor.
Searching for a business will never be as simple as searching for a property or a car, but with an understanding of the principles of business valuation the process is much quicker and easier.
If you would like to learn how to value small businesses, download our free eBook now!
* For larger businesses, comparables are easier to find. The PERDA database, for example, shows the price-earnings ratios of companies that have sold recently in the UK, with an average enterprise value of £21.4m in the most recent survey. There is no such database for smaller companies.