Business Valuation and Keeping Up With the Joneses

Three Ways to Put a Price Tag on A Business

1. Comparable Market Analysis
2. Asset Approach
3. Earnings Approach

The comparable market analysis is similar to how a Realtor places a price tag on a residential home. Using recent sales data on similar homes, they adjust the price up o

r down depending on superior or inferior qualities - e.g. your house has 2 full baths, a house that sold recently had 3, thus the price your house will be listed at compared to the other will be adjusted down.

The same goes for a business being sold. Market data can be obtained through business appraisal associations and prices can be adjusted up or down.

The asset approach is simply taking the market value of the assets within the business and saying this is the price tag. For example, let's say you have a business with a building and one oven for simplicity's sake. Let's say the market value of the building is $150,000 and the oven is worth $2,000. The asking price is therefore $152,000.

In the earnings approach, the past earnings are averaged and then divided by a capitilization rate, typically thought of as the rate of return one wishes to achieve. For example, let's say a business had earnings of $100, $75 and $125 over the past three years. This averages out to an average earnings of $100. Divided by a capitalization rate of 20% means the business is worth $500. Typically the earnings will be adjusted, adding back in discretionary expenses (meals, travel, home office) and excess owner's salary over and above what a normal manager should be paid.

Keeping Up With the Joneses

One key attribute of a Warren Buffett business is that it has the ability to incr

ease prices to inflation. A business that can increase its prices will increase its earnings per share - the number of shares remain static but the earnings go up due to an increase in prices.

A McDonald's hamburger cost $.15 in 1955 and $.95 in 2011. A ticket to Disney cost $3.50 in 1971 and cost $80 in 2010. Both of these are examples of businesses with the ability to increase with inflation.