Investment case for you: would you buy this business?

I just responded to an interesting thread (http://thefastlanetomillions.com/showthread.php?p=28476) in which business valuation was discussed.

I thought it might be worthwhile to give you a simple case where a business is for sale, to see if you'd buy it, and what price you'd pay.

The (fake) case

A widget company based in Somewhereville, USA.

• Income: $20,000 per month from widget sales.
• Expenses: $8,000 per month (salaries, insurance, lease)
• Gross profit: $12,000.

I am purposely making the financials this simple to reduce the complexity of the decision. I am also purposely not posting a balance sheet. Not for this example at least.

EDIT - This is a completely passive business. You are evaluating a going concern, which doesn't require any (mandatory) presence of yours.

The question

1. How much would you pay for this business? Providing this business performed exactly as I described above, every month for the next 25 years, how much would you pay?
I want you to write a number. Just analyse what it would be worth under these conditions.

2. How did you come up with this number?

3. What are the key things you want to know before you'd invest?


I'm looking forward to this, I like working this stuff out. Hopefully you do too!

Daniel.

Should this go well, would you like me to post a more complex, maybe even real-life case regularly?

I think valuing investments is a vital skill that needs to be developed, and here is a great place to get some practice in.

Daniel.

I have a few questions. You can't evaluate the business based on its monetary numbers only. How many hours per week do I have to put into this business?

Is this an online business? Is it retail? B2B? Number of employees?

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Agreed with Biophase that you need a lot more information about a business before you can determine its value...this is why M&A (merger and acquisition) teams spend weeks, months and sometimes years doing evaluations before making a decision on whether to buy and for how much...

I just edited my post to mention that it's a passive investment you are evaluating. Thanks for reminding me that I forgot this.

There's a specific way of thinking about this that I wanted people to discover, if they didn't know it already. I debated with myself for the last few moments whether I should just write it, and I will (otherwise this thread might become a bit of a mess!)...

This example is all about asking yourself "How much am I prepared to pay for this stream of cash flow?"

Bio's questions are very important, but I want to leave them for another case.

How much would you be prepared to pay for this business if it generated $12K a month for the next 25 years, guaranteed, and was a passive investment?

Daniel

(Sorry for not being a bit clearer!)

Based on above, I'd be willing to pay about $1M, as I think a 15% completely passive, non-compounded (simple) return is about the best I could do with other investments I might consider (assuming I did my math correctly ).

:-) It makes me very happy that this answer was posted. Just to clarify, I think you mean a T-bond/bill :-) Nice work!

I'm typing in the dark and am too tired to be able to really read into your post, but Microsoft Excel and OpenOffice Calc can do these calculations. :-)

entirely passive investments still carry risk and I would expect a return of 15% on my money. Otherwise foreign funds can provide zero risk at 7-8%. A mistake I see many people make in buying businesses is that they choose to buy a J-O-B and dont take in consideration the effort to focus on the big picture for the business is just as demanding as running day to day operations, but the same person will have difficulty doing both especially recent retirees shifting from corporate worlds.

but to answer your Q-
Assuming there are no carrying costs for funding, I would pay 800k to net an 18% return cash on cash investment and 144k annual income.

alternative would be to buy real estate using same parameters but the net worth is more tangible and would expand after costs.

I agree with TheGreatBear,
this isn't a business eval,
this is a bond eval.

For a business eval,
you'd start with a NPV of cashflow discounting at 10%+ for the first 10 years
(adding on current NBV and adjusting from there).
Why 10 years?
Because it is darn difficult to project any business out past a decade.
Even when I eval'ed solid blue chips, I didn't look past a decade.

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I've seen some excellent thinking :-)

It is indeed just a bond valuation in a different form.

Kimberland's comments on the difficulties of projecting into the future are right on the money :-)

Excellent discussion, I'll have to get a real case and we can add the beautiful chaos created by all the other aspects of business!

Oh, and some reputation points as well!

Great thread, Auzzie!! Thanks for starting it. ++++

I am new to the business evaluation process - currently devouring books on the topic - but, for now, I would go with Randall. I have been looking at it from a return standpoint and it will have to be at least 15%.

I also need there to be a clear and sustainable path for growth.

Without additional info, my answer would be 960k max.

And, yes, I would love to see 'more complex, maybe even real-life cases posted regularly'!! I certainly intend on posting (in disguise) my potential candidates and think the practice might be great learning for everyone.

austrailianinvestor, excellent thread. Speed +

This will be a great start to my education of business analysis I hope you keep going.

Without trying to be cute, did you just read a book on this or is there another thread where we can find your credentials to write about the subject?

Off hand I went with the 15% return and $960,000. What bothers me is the debt of $960,000 and the risk involved in getting that paid off in a timely manner. Things change on a dime these days. I would want the debt paid for in 5-7 years.

Thanks for the thread.

I don't have any experience in evaluating businesses, but I feel like everyone is offering very high dollar amounts.

My initial reaction in evaluating this biz before the additional information was:
If its restaurant: $250,000
If it has no employees home biz: $360,000
At 100% passive: $1,000,000 is a 14.4% return

Problem is that we can't evaluate risk. But if you assume that it will shoot off $144,000 a year for 25 years and that is set in stone. Then you can offer alot more than $1,000,000. The question is what happens after the 25th year? Can it go another 25 years?

I'd think that most people who buy a business with hopes of increasing its sales and revenue. If you say that revenue is fixed, then it really has no upside, just alot of downside.

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I have an MBA, have owned a number of companies in two countries, and have analysed more deals than I care to remember :-)

If you want to learn more, the basics can be found in finance and accounting courses/text books. :-)

Curious excercise...


$720,000.00 would be my highest bid... I would expect a minimum return
on initial investment of 20% because of the risks that are involved in
the business and some mad prvisions for inflation and Taxes...

I do not know what the situation is like on your end australian investor
South African businesses tend to sell on a payback period of 3 years
which would give a value 432,000.00 thats cool. It is generally cheaper
to buy whole small businesses here than shares I have learned.

Things get complicated if the seller starts to telll you about the growth
portential of the earnings.

Anyway this is what I would want to know...

1) Why are you selling...
2) What is the Free Cashflow from the business...
that is how much can I take out of the business without harming future cashflow
3)What is the historic growth in earnings
4)Are the earnings of good quality...

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While I appreciate this exercise as it has generated a lot of brilliant (and true) comments, evaluating a business looking only at these numbers would be like buying a car because it has sparking rims and new tires.

Until you look under the hood, check the CarFax, service records, comparables in the marketplace, no value can be placed.

Now based on the information presented (removing the 25 year cash flow guarantee), I wouldn't pay more than 3 Times net earnings and here is why:

1) The product is a widget and manufactured in the US.
2) The owner is experiencing high margins.
3) Since high margins are being realized, new competitors will enter the marketplace and start eroding the margin.
4) New competitors will most likely manufacturer the product in China ... further escalating the margin deterioration.

This is why such a business can't be properly valuated -- the market, the competition, barriers to entry all are apart of the business valuation recipe -- its been omitted in this exercise hence no answer is right or wrong.

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I took the question to be predicated on Aussie's following comment:

As TheGreatBear pointed out, this can then be reduced to evaluation as a bond or other fixed-return investment.

Of course, though, I think we all agree that this isn't a realistic description of any existing business...

just a few hours ago I was talking with someone who is looking to sell their biz and thought of this thread....

revenue- almost 1mil
net profit after all expenses - about 10% (100k)
some possible opportunity for growth, but with added expenses
little competition at this time

my offer was probably a little insulting at 300k but the reality is that if he does not sell the biz, then it disolves... there is no inventory and goodwill does not go very far in todays credit climate.

Is it prudent to use the 25 Year bond valuation process given that the cashflows of this business are at best guesstimates in the 3rd year and further. Someone mentioned Buffet earlier and I did a bit of revision... His investments have generally had an initial ROI (return on investment of 5% the 89 coca cola purchase I think was actually about 11%. Moreover he is buying businesses with growing earnings that is why he is willing to pay 20 times the company's earnings. He figures if the earnings continue to grow like this I should be able to get back my initial investment in 5 to 7 years. With the figures supplied. That is there is no mention of growth in earnings. Focus on returning your money in at most 7 years from those cashflows.

I have not yet read on real estate investment... I generally know that the payback period for real estate from rentals is normally that high. Which brings me to the question why do banks prefer to finance assets that willl payback over such a long period of time rather than small businesses that can pay back in less time.

randallg99 is really not being rude by asking for that much (well little if you like) ... I think its in the model. see www.aldes.co.za for sellers on another planet who are selling for no more than 24 times monthly profits for sweet businesses. P.S South Africa is much more stable than Zimbabwe and these businesses are in Saouth Africa

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