Hello S. Breth,
I value a partnership in a bar/restaurant in the same way that I value all propositions. From my blog:
Present Value of Future Revenue Streams
The Art of Assumption
This methodology allows the calculation of the net worth of a company in today's dollars. For example, if you know that the business will receive a lump sum of $10,000 at the end of 5 years - how much money would you need to invest today to accrue that sum by that time?
Really doesn't sound that complicated, does it? But wait a minute, are you going to invest in a 5 year CD that will be locked in at a higher interest rate or do you prefer to invest in a savings account that is more accessible if you need it?
The difference in interest rates - spanning 60 months of compounding - can quickly change the present value. A lot of folks use the Adjusted Federal Rate published by the IRS every month. Here's an example: applicable-federal-rates-march-2009.
This rate will give you a reasonable average interest rate but it does not necessarily address the primary purpose of calculating the Present Value (PV) of future streams: opportunity costs. If, for example, you have a real opportunity to put your money in a red-hot, sure-fire investment that will return 20% every year, you should apply that rate to determine the PV of the lump sum (immediately after you call me about this investment).
As you know, in real life - nothing is ever this simple. The Present Value of any cash value, be definition, presumes a Future Value and anytime you begin predicting the future - you're taking a risk. The current economic calamity is a painful case in point. The best you can do is to make conservative assumptions and - if you discover that you've underestimated the future value of a business and/or investment - you can celebrate the difference.
Mechanically, there are two ways to compare investments:*
1) Using the same interest rate, determine the PV of your various investment choices and compare these PV's to the amounts that are required by the seller/fund. This method has the advantage of allowing you to analyze alternatives with dissimilar structures and value. For example, let's look at the following alternatives:
Alternative Price Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Total Cash Flow
#1 $10,500 $15,000 $15,000
#2 $7,979 $3,000 $2,500 $2,000 $2,000 $9,500
#3 $12,500 $2,000 $2,500 $3,500 $4,500 $5,500 $18,000
How do you evaluate these scenarios? Use any interest rate you want - since it will be applied to all three, the decision will be the same regardless of the rate. Let's just select 8% for the purposes of this illustration:
Alternative Present Value Sales Price Difference
#1 $10,209 $10,500 $291
#2 $7,979 $7,979 $0
#3 $13,824 $12,500 -$1,324
The beauty of this method is it's ability to level the playing field so that you're not comparing apples and oranges. Let's take a look at the relative returns on investment (ROI) to better understand:
Alternative Rate of Return
If you were to only compare relative interest rates, the 3rd alternative is the obvious choice to make. However, only using interest rates gives you no sense of the absolute amounts involved. You might find that the highest interest rate only involves $1,000 or $1,000,000 - or one payment at the end of a decade or many smaller payments on an annual basis.
This is not to say that the comparison of interest rates is not a valuable tool - it should be part of your analysis - in conjuction with the comparison of PV to sales price.
*Incidentally, I used MS Excel to calculate the PV and ROI - most calculators offer the same financial formulae. A few small pieces of advice if you use MS Excel functions named NPV and IRR - remember to enter a zero for those years that have no income or expense; income flows are positive; investments and outflows are negative.
One final note on using the present value of future revenue streams to value a company:
While using this method gives you a general tool to rank various investments - you are still presuming that these cash flows will materialize. For an annuity, that's a safe bet - for a small business, it's a risk - how much of a risk is up to individual judgement.
For more advice about how to buy, sell, or evaluate a business, please visit: http://www.AustinBusinessesForSaleBlog.com
Julie A. Barnes, CPA
President, SBX, Inc.