A colleague recently approached me to discuss his dream of buying a cafe and saying goodbye to his boss forever. He noticed that there were a number of cafes for sale in the newspaper but had no idea how to value the business. I am glad he decided to seek advice because paying too much for a business is a common mistake which can have drastic financial ramifications. Cafes in particular are difficult to value because they are a cash based business and 90% of owners are unable to prove their figures on their financial statements. I also wanted to make sure my colleague appropriately considered the attractiveness, or unattractiveness as the case may be, of the cafe market. I could see he was in the grip of the entrepreneurial seizure, bursting with enthusiasm and confidence, but was it even a market he should enter? He wasn’t aware that 70% of cafes fail within the first year or that cafes change hands every 2 – 3 years. He also failed to notice that between 50% – 60% of small businesses sold in the newspaper are food related which indicates the level of competition. It is important when buying a business to keep your emotions out of the process. The price you agree to pay must be based on true value and not intrinsic factors or the romantic notion of being self-employed.

Valuing a business

There are a number of ways to value a business and I will now outline a simple method which most people will understand. To keep things simple I am not going to go into tax and cost of sales, but will base the calculations around profits or net cashflow. For the purpose of the lesson, lets assume the following.

Listed sale price = $750,000

Net weekly profits = $2,000

Time you plan to own business – 10 years

Average available interest rate = 6%

Step 1: Yearly net income = $2,000 x 52 weeks = $104,000 per year

Step 2: Income stream of planned 10 year period = $104,000 x 10 = $1,040,000

In effect, you are buying an income stream for 10 years. The business is worth the present value of that ten-year income stream.

Step 3: Present value = Future value/(1 + r)¹º (note: r = interest rate)

= $1,040,000 / 1.06¹º = $580,730

What this means is that you would need to invest $580,730 for 10 years at the average interest rate 6% to earn a total return of $1,040,000. Therefore the asking price of $750,000 is too high and $580,730 would be the appropriate sale price based on value.

But it doesn’t stop there. Lets say you are looking for a greater return on your investment. We will assume that you can achieve a 8% return on your money in other investment types and expect the same return from a business you want to buy. Using the same formula , you would insert 8% instead of 6%. The result is $481,721. Therefore you make an offer of $481,721 for the business and if successful you secured an investment returning 8% compounded annually for the 10 year period.

If you paid a price of between $580,730 and the asking price of $750,000, you would be speculating that the business will do better than past results. This would be considered a risky approach. If you secured the business for less than $580,730, you would be getting a better than average return on your money.

I hope this simple approach to valuing a business is helpful. I will present other more in-depth methods in future post. Please leave a comment and let me know if it has helped you.

Tony Grima