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How To Investigate Any Business Opportunity
Using comparable sales as a means of valuing a business has the same inherent flaw as rule-of-thumb
formulas. Rarely if ever are two businesses truly comparable. However, businesses in the same industry
do have some characteristics in common, and a careful contrasting may allow a conclusion to be drawn
about a range of value.
Balance Sheet Methods of Valuation
This approach calls for the assets of the business to be valued. It is most often used when the business
being valued generates earnings primarily from its assets rather than the contributions of its employees
or when the cost of starting a business and getting revenues past the break-even point doesn't greatly
exceed the value of the business's assets.
There are a number of balance sheet methods of valuation including book value, adjusted book value,
and liquidation value. Each has its proper application. The most useful balance sheet method is the ad-
justed book value method. This method calls for the adjustment of each asset's book value to equal the
cost of replacing that asset in its current condition. The total of the adjusted asset values is then offset
against the sum of the liabilities to arrive at the adjusted book value.
Adjustments are frequently made to the book values of the following items:
Accounts Receivable - often adjusted down to reflect the lack of collectability of some receivables.
Inventory - usually adjusted down since it may be difficult to sell off all of the inventory at cost.
Real Estate - frequently adjusted up since it has often appreciated in value since it was placed in ser-
vice.
Furniture, Fixtures, and Equipment - adjusted up if those items in service (probably more than a few
years) have been depreciated below their market value, or adjusted down if the items have become ob-
solete.
Income Statement Methods of Valuation
Although a balance sheet formula is sometimes the most accurate means to value a business, it is more
common to use an income statement method. Income statement methods are most concerned with the
profits or cash flow produced by the business's assets. One of the more frequently used methods is the
discounted future cash flow method. This method calls for the future cash flows (before taxes and before
debt service) of the business to be calculated using the 4-step formula below.
Step #1
The historical cash flows are a good basis from which to project future cash flows. Cash flows are com-
puted to include the following:
1. The net profit or loss of the business.