Proof in the Pudding
Typically, three approaches can be used to fix a price tag on a business and prove the expansion of value: the asset-based approach, the comparable market analysis approach and the earnings approach.
Think of the asset-based approach this way: you decide to sell me your lawn care business which is comprised of two assets: a lawn mower and a weed eater. After 10 years of neglect, lack of oil changes, blade sharpening and being tossed in the back of a truck, the equipment is on its last legs. The clientele of the business should not be included in the valuation we decide since most are angry about their half-trimmed yards. The equipment brand new costs $1,500. We settle on $150.
The comparable market analysis approach echoes the method used to sell residential real estate in which the selling prices of comparable homes are adjusted up and down based on superior and inferior qualities; except in our case, we use businesses instead of homes. This approach is useful in valuing non-productive assets such as the 10 acres of land sitting under a cash-flowing donut stand but it lacks the ability to value productive assets.
The earnings approach accommodates for this and uses the accounting net profit with discretionary items and non-cash expenses added back-in. This figure is then divided by a capitalization rate in order to reach a business value. The capitalization rate is equivalent to a required return on investment and can be thought of as the level of perceived risk in the business, ranging anywhere from 20 percent to 40 percent for small business. For example, if the donut stand averages $50,000 a year in earnings and we use a capitalization rate of 20 preecent, we arrive at a value of $250,000. ($50,000/20 percent).
This approach is most similar to how Warren Buffett values the future share price of a business, projecting forward a future value and rate of return based on earnings per share and growth.
Increasing Return During a Downturn
Another good reason to be a small business owner today is found in the opportunity to increase returns as a result of cheaper inputs. Warren Buffett identifies quality businesses with a durable competitive advantage, a strong earnings track record, a high return on equity and the ability to reinvest in the compounding engine. He does not merely look for the discarded cigar butts with one or two puffs left in them. He identifies great companies with a durable competitive advantage and then patiently waits for them to go on sale.
His argument is that if he can buy a company today for $31 a share and it will be worth $80.40 a share at the end of 10 years, then his annual rate of return will be 10 percent. If he can buy the same business for $26 a share, then his return will shoot up to 11.95 percent. In a downturn, great businesses go on sale.
Similarly, the owner of a small business with a durable competitive advantage can purchase cheaper inputs such as labor and materials during a draw-back and increase returns over the long haul.
Typically, bigger fish with solid financials can outlast competition during recessions and price wars. Thus, the survivors of tough economic times, those with durable competitive advantages, can emerge on the other side to find a clearer field, bereft of distracting competition and chock-full of new market-gap opportunity. Good businesses will shine while mediocre businesses will wane.
Help Is On the Way
Additionally, with a federal focus on job creation, new programs are available to assist small business owners, programs such as the Hiring Incentives to Restore Employment Act and the Small Business Jobs and Wages Tax Cut.
It’s a great time to be a small business owner because of fundamental, underlying asset building principles, the opportunity to increase returns in a draw-back and the reduced competition. The owner of a small business can increase asset value over time just as Warren Buffett seeks out investments with a clear, underlying ability to expand in value over time.
Adam Brownlee is author of "Building a Small Business Warren Buffet Would Love."