HOW TO BUY AN EXISTING
BUSINESS OR FRANCHISE

Business Valuation Models
The next step would be to determine the value of the company. There are many different ways to value a business: fair-market valuation, liquidation value, book value, cash-flow based valuation (e.g., multiple method, discounted cash flow method). It is recommended that the buyer contact a good accountant to determine the value of the business.

Two of the most common valuations to determine if the purchase will be a good move are:

• Net Present Value (NPV) (13)
• Internal Rate of Return (IRR) (14)

Both methods are closely tied together and consider only the business’s cash flow over a set number of years. A business calculator or a spreadsheet program can be used to determine these values. Doing them by hand is not recommended. Again, an accountant can help if the buyer is unfamiliar with this type of analysis.

NPV is based on the thinking that money today is worth more than money tomorrow. Money that is due to arrive years from now suffers a penalty in terms of opportunity cost, inflation, and overall risk. To compensate for that, accountants introduce what is called a discount rate (15) at which the future profit figures are time-corrected downward. The amount of the discount rate depends in large part on the expectation of the individual performing the calculation. If the business is extremely risky, one might use a higher discount rate to compensate. Likewise, if the business is relatively safe, a lower discount rate may be appropriate. The calculation of NPV takes into account the initial investment (large negative number), and the projected profits for the next few years (3-5 years is common). Once the future profits are discounted back to today’s dollars, they are summed and the initial investment is taken out. The result is the Net Present Value of the cash flows. If the NPV is positive, the project is profitable. If the NPV is negative, the project will lose money.

For example, let’s say a business will cost $50,000 to purchase, and will make $10,000 in the first year, $20,000 in the second year, $30,000 in the third year, and $40,000 in the fourth year. The business is moderately speculative, so a discount rate of 25% will be used. The Net Present Value would be $2035.20.

It is clear that the NPV is highly dependent on the chosen discount rate. A higher discount rate would reduce the value of the future cash flows and make it more likely that the NPV would be negative.

The next valuation, the Internal Rate of Return (IRR) looks at what discount rate the NPV will be zero. In our example, the IRR was 27% meaning if we chose to run an NPV calculation at 27% rather than 25%, the NPV would equal 0.

The IRR gauges the risk in many respects. If the IRR is low, it shows that the project in question is high risk. There wasn’t much buffering capacity and a slump in sales could mean the difference between a modest profit and a net loss on the deal.

Continue to Step 4

Return to Step 3's Ratio Analysis

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