Before acquiring an existing business, you need to carefully evaluate the asking price.
No two valuations are the same, even for companies in the same sector.
Unfortunately, there are no valuation tables based on a company's size, earnings or sector of activity.
First, you need to make a clear distinction between revenues and profits. Revenue" refers to gross sales before expenses, and "net profit" refers to the sum remaining after all expenses incurred to generate that revenue have been deducted.
When valuing a going concern, it is very important to calculate normalized net profits or earnings.
There are two basic methods for valuing a company: liquidation value and going-concern value.
Liquidation value is calculated by deducting liabilities and reasonable liquidation costs from the current market value of all the company's assets. The resulting value is the amount you would receive if you sold all assets and paid off all liabilities. This is what the company would be worth if it were "liquidated".
This is the minimum ceiling of the company's value. Or in other words, how much will you have left if you sell all the company's assets, and pay off all the debts.
Calculating going concern value
Calculating going concern value is considerably more complicated.
It is important to "normalize" earnings by eliminating the impact of assets or revenues that are not part of the company's core assets or main revenues. These ancillary assets and revenues are valued separately. An appropriate capitalization rate reflects a reasonable level of risk given the nature of the business.
Always remember that in the business world, return equals risk, so if you're hoping to receive a high rate of return, you should be prepared to take on more risk.
The fundamental question
The fundamental question to ask when valuing a company is this:
How much am I willing to pay for a business if this amount will allow me to earn X Shekels a year from this business?
To calculate this value, examine the earnings history and make the necessary adjustments to take account of the financial impact of non-recurring events, for example, abnormally high one-off non-recurring earnings or expenses.
Don't forget executive salaries
An adjustment may also be necessary to take into account items such as "normal" executive salaries, i.e. the amount the company would have been required to pay in salaries if it had hired a manager at market rates.
How do you calculate the appropriate capitalization rate?
Once you've determined the likely amount of future "normalized" earnings, based on historical data and trends, choose an appropriate capitalization rate. Consider the level of risk associated with the business and the rate of return on other types of investment.
To put things in context, check the current rate of return on savings accounts, which are risk-free and can be cashed in at any time. Compare this to the rates of venture capital firms, which charge compound annual rates of return of 25 % to 30 % because they invest in high-risk companies and their investments are not guaranteed. Most companies' returns fall somewhere in between.
Before committing yourself to the purchase of a business, you should seek the advice of industry experts and professionals who can guide you through this exciting and risky project.