© Copyright 2002-2003. All rights reserved.
Page 38
How To Investigate Any Business Opportunity
that the purchase or sale of the business would not be wise.
With forecasts covering more than 1 or 2 years, a more detailed forecasting technique is needed. Such
technique should be designed to weight out extreme variations in year-to-year sales and to give a trend
or level of sales change that is more realistically oriented to probable future sales patterns.
No method of forecasting can set any value on external market conditions, because there is no guaran-
tee that these conditions will carry over into the future with the same relative significance. Nevertheless,
their possible influence should be considered.
Risk and Return on Investment
If a buyer wants to invest money in a business that is being sold, he should be concerned about receiv-
ing a fair return on his investment.
Many businesses can make a profit for a short time (1 to 5 years) ; not so many operate profitably over a
longer period of time.
From the buyer's point of view, what is a fair rate of return from an investment in a small business? The
rate of return is usually related to the risk factor - the higher the risk, the higher the return should be.
The buyer of a small business should try to determine the risk factor of the new business, though this is
difficult at best and in many cases impossible. In attempting to assess the risk factor, the buyer should
project the profits of the business as far into the future as possible. He should ask himself how high the
risk should be normally and look for conditions that would be likely to affect the sales and profit-making
capability of the business.
In any event, he should consider carefully the minimum return on investment that he is willing to accept.
This concept of risk is important in valuing the business by capitalization of future earnings.
Valuing the Business by Capitalizing Future Earnings
The price to be paid by the buyer should be based on the capitalized value of future earnings. Instead,
however, in most small business buy-sell transactions, price is based on the purchase and sale of as-
sets, Profits are made by utilizing assets, of course, but actually the assets purchased are only inciden-
tal to the future profits of the new business.
Capitalized value is the capital value that would bring the stated earnings at a specified rate of interest.
The rate used is usually the current rate of return for investments involving a similar amount of risk. The
capitalized value is found by dividing the annual profit by the specified rate of return expressed as a