Valuing A Small Business

Business brokers and other professional intermediaries use business valuation rules of thumb to help sellers price their businesses for sale. These "rules" are very useful for appraising nearly every small business, however they are gross simplifications and should only provide a general idea of a suitable price range for a particular business.

If a rule of thumb is used to value a business, some type of earnings multiplier makes the most sense to prospective buyers. It directly addresses the buyer's motive to make money to achieve a return on investment. Sales multiples mean nothing unless they can be translated into earnings.

Two areas of confusion are inappropriate comparisons to investment real estate or to stock market earnings multiples. Real estate is often priced at 8 to 10 times its net operating income. Stock market prices are often as much as, or even more than, 20 times earnings. These two comparisons do not work for small businesses primarily because the risk of owning a small, closely-held, privately owned business is thought to be much higher than owning either real estate or publicly held stock. A business has lower liquidity than real estate and stock, and running a small business is also a lot tougher than managing an office building or a stock portfolio.


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