A Useful Business Valuation Method in "How to Buy a Good Business at a Great Price"

I guess I’m kind of a business valuation nut.  I enjoy learning the theories behind business valuation methods, and I like trying to understand why various methods may or may not work.   As I’ve written before, it all comes down to the future cash flows enjoyed by the owner.  However, since we can’t predict the future, there are various valuation methods that basically help us do just that. Some, such as using a rules-of-thumb multiple on historical earnings, assume continued stable earnings and completely ignore trends and problem areas the company may have. 

Richard Parker, in his program “How to Buy a Good Business at a Great Price” focuses on this problem in his “Diomo Business Assessment Method” by using a risk analysis checklist (a spreadsheet in Excel).   This checklist walks the buyer through the process of analyzing the risk associated with the business.  In other words, if there is substantial risk that the earnings may not continue as they have been, the business is certainly worth less. 

For example, the checklist addresses customer concentration issues by asking questions like, “Does any single customer own more than 20% of the business”, and “Do the top four customers own more than 50% of the business”.    In all, the valuation program asks perhaps 30 questions relating to the strength and risk of the business. 

Let’s compare this method to a standard business valuation that would done by my partner, Fred Hall, who is a trained business appraiser.   The Diomo method applies to smaller businesses, say with earnings under $500K.  For these types of businesses, Fred would use the market approach, where he dives into the “done deal” databases and pulls out comparable transactions.  He tries hard to find companies with the same profile and the same size as the target company.  The result is typically a standard bell curve of valuation points, with some “sold” companies valued low (the tail of the curve) and some valued high (the other tail), but with the bulk valued toward the middle, or the fat part of the bell curve.

Fred does attempt to ferret out risk factors of a company, and adjust the company along the valuation curve accordingly.  For example, he will ask about customer concentration issues.  At the end of the process, the company may be valued at the average of its peers, or if there are enough risk factors, it will valued down towards the bottom tail or, converseley, up on the upper tail.  (By the way, for those into statistics, Fred also does multi-variable regression analysis, where he collects data and builds a model on relevant sold companies.  He then collects data on the target company and throws that data at the model.  The model figures out what data is statistically relevant, and then calculates a value).

The difference between Fred’s valuation and the Diomo method is this.  Fred, and other professional appraisers don’t have the time to research and pull out every single risk factor, and sellers often are not forthcoming with every piece of negative information.  You, as a buyer, want to dig deeper and longer to fully understand the company and how that company may perform in the future.  In addition, there are some risk factors that are specific to the buyer, and you certainly want to take these into account.  The Diomo program prods you to consider these by walking you through the standard risk issues.  It then attaches weights to the risk items and uses these in a calculation on earnings to arrive at a valuation.

The bottom line is this.  The Diomo method is extremely useful for buyers to determine a good value that THEY would pay.  A professional appraisal is more relevant for the seller, and provides a value that the market typically pays for their type of business.  Understanding this, you can use both to move towards a common ground.  Also, and this is important, know that a professional appraisal is not cut and dried like many would lead you to believe.  Remember that bell curve and the tails.  You can use the Diomo method to highlight risk factors and show that company might be further down on the tail, and cheaper in price.  Or, less common, it may indicate that you should just quietly pay the asking price and buy the business.