How to determine the value of a business
Are you buying or selling a business?
Either way, it's good to have an accurate idea of how much a business is worth. There are a bunch of confusing industry standards out there and all sorts of formulas you can use, but there are also some rather simple rules of thumb that will get you a decent ballpark figure.
I've found that you don't need to be 100% accurate when pricing a business, because you CAN'T be 100% accurate. Nobody knows how much an asset today will be worth 10 years from now, so how can we put a price on that? You could spend tens of thousands of dollars hiring expert business brokers and appraisers and well-educated finance guys and they'll give you specific amount that'll probably be right around your ballpark figure, and neither will be more accurate than the other.
Business owners cheat on their taxes
Alright, here's the deal. You can find out a lot of information about a business's finances by looking at the tax records, but you've got to be aware of the fact that most small businesses try to fudge the numbers at least a little on their tax returns. The IRS has come to expect this type of behavior. Small business owners will under report their earnings while over reporting their expenses. If your tax sleuthing indicates a business only made $50,000 profit last year, there's a good chance the owner actually made much more than that, he just reported a lot of every-day expenses as business expenses by connecting the expense in some way to the business.
The rules of thumb
Not all businesses are valued the same. A bakery making $50,000 profit a year might be valued different than a textile factory making $50,000 a year. For each industry, there are certain rules of thumb to determine the multiplier to come up with a total business value. The best guide that I'm aware of is the Thomas West Handbook of Business Valuation. It's a 600+ page guide to nearly every industry you can think of. Valuing Small Businesses and Professional Practices by Shannon Pratt is also a good guide.
What comes with the business?
If you're buying a business, you need to ask yourself exactly what you are getting. For brick and mortar businesses it usually means a building. Will you own the building or is it leased by the business? Also, is there any land attached to the business? How valuable is the business's brand name? Is it locally well-known? Regionally well-known? These are things that you have to take into consideration.
Just to give you an example, there's a very popular barbecue restaurant near where I live. This restaurant probably makes over $1 million profit a year. There are many models that will give a precise multiplier to determine how much this business is worth, but I think they'd all be wrong. Why? Because this business has been around for 70 years and has an established name. Everyone with a 200-mile radius has heard of this restaurant, and many people from much farther away know of it. They love the food, and they especially love the sauces. The restaurant has just recently opened a sauce factory so they can sell their sauces all around the world, but that part of their business hasn't been fully exploited yet. Their sauces have sold very well so far, but I expect in 5 years time their sauce business will dwarf their restaurant business. If this business had publicly traded stock, I would be investing now!
What are some alternatives to investing in this business?
Before you jump in and buy an established business, you should look at some investment alternatives. If you're going to be making 5% of your investment back in profit each year but a guaranteed government treasury bond is paying 5.5%, are you really better off owning the business with all the extra risk involved? You want your business to be making profit well in excess of alternative investments to offset the huge amount of risk involved in owning a business. People in the investment world call this gap a "margin of safety".