Valuation 101: My formula for finding winning businesses

A huge mistake I see people make during their first acquisition is not learning how to properly do a valuation.

Without this skill, you can easily end up overpaying by hundreds of thousands of dollars for a business that looks great on paper, but ends up being a dud.

How do I know this?

Because I’ve built a portfolio of 8 businesses over the last 5 years, and I’ve been profitable on all 8.

Not by luck, either — I just know what to look for.

The good news is, identifying winning businesses is actually pretty simple.

Let’s say you’ve got two HVAC businesses, A and B.

They’re both on the same street, both priced at $1,000,000, and cash flow for both in 2024 was $400,000. Therefore, the multiple is 2.5x.

If you focus on just those numbers, these businesses look identical.

But this is only a surface-level valuation.

To get an accurate multiple, you have to look at two other metrics:

1. The market value

2. The management structure

For the market value, we want to look at the last 3 years of cash flow, not just last year’s.

To avoid overcomplicating this example, let’s say both business have the same cash flow over 3 years:

2022: $300k
2023: $350k
2024: $400k

Which evens out to an average cash flow of $375k.

So far, so good. Both businesses are still identical.

That means the deciding factor will be the management structure.

In Business A, the owner runs the day-to-day, and it can’t operate without them. Because of this key-man risk, this drastically lowers the value of the business.

So, Business A’s multiple will only be about 2-2.5x.

(Multiples are usually between 2x-4x, so this is low!)

On the other hand, Business B’s owner only works 5-15 hours per week, with a general manager in place who runs the day-to-day for 40 hours per week. It’s much easier to sell this business and replace the owner without disrupting operations.

That means Business B’s multiple will be somewhere between 3-3.5x.

This is a huge difference!

Again, both businesses have an average yearly cash flow of $375k. So once we apply those multiples, their total market value becomes:

Market value of Business A: $750k to $937.5k
Market value of Business B: $1.125M to $1.312M

Since the purchase price is $1M, that means Business A is a bad deal, and Business B is the clear winner.

Those are the basics of how to properly do a valuation.

There’s more nuance to it, of course... but understanding these fundamental concepts will give you a huge leg up as you start navigating your first deals.

If you’re considering buying a small business (or passively investing into an acquisition), and want me to send you proprietary deals:

Tell me your goals and budget here.

Or if you’re looking to sell a business and would like me to send you qualified buyers:

Let me know here.

Onward,

— Ben Kelly