How to Value a Business: The Returns Approach

Back in Part 1 of this series, I told you that businesses will typically sell for anywhere between two to four times earnings. Today I'm going to show you exactly where that number comes from.

Every serious buyer who looks at your business, from a first-time entrepreneur through to a seasoned private equity firm, is going through the same thought process. Most brokers never really explain it to sellers, but once you understand how buyers actually think about your business and why they offer what they offer, you're in a better place to negotiate with them.

The Returns Approach

This is Part 4, the final part of my series on business valuation. In Parts 1 through 3, we covered the three standard approaches to valuation: the Market Approach, the Income Approach, and the Asset Approach.

Today we're covering what I call the Returns Approach. It's the method that most brokers won't walk you through, but it's one that I use in almost every valuation I do, because it reflects how buyers actually think.

I'm Ed, a business broker and the founder of Sundance Financial. We help small business owners sell their companies all over the US. Now let's get into it.

The Buyer's Question

Here's the thing about the first three approaches: they're all trying to answer the seller's question, your question, which is what is my business worth? The Returns Approach flips that around and asks what the buyer is more likely to be asking: at what price can I purchase this business and still earn a reasonable return, given the risk I have to take?

Because at the end of the day, buying a business is really just an investment. If we step back and think about the buyer's alternatives for a second, they could put their money in something like the S&P 500 and earn 8% to 10% per year without thinking too much. If instead we're asking them to take that same amount of money and put it into buying your business, to take on the risk and probably work in the business full time, they'll need a return that's a lot better than that to make it worth their while.

So the first thing a buyer will often do is start with the return they need, and then work backwards to the price they can pay to get that return.

Simulating the Investment

Before we get too deep into the mechanics, let me give you an overview of what we're actually doing here. What we want to do in the Returns Method is put ourselves in the buyer's shoes and simulate the investment from their perspective.

Put simply: there's a price the buyer pays on day one. That's what they pay you. They then collect the business's cash flows every year they own it. And finally, at some point down the road, they probably sell it and earn a bit of cash then too.

That's the entire lifecycle of the investment. Money goes out at the start, then money comes in while they own the business, and then money comes in again once they sell. Once we've completed that simulation, we can simply find the price at which buying your business earns the buyer a reasonable return on their investment.

Bookends, Not a Single Number

One thing I want to note upfront: the output of this exercise isn't necessarily a single number. Instead, I like to think of it as a set of bookends. There's a price at the top end that works for a buyer who sees a stable, lower-risk business, and a price at the bottom end that a buyer who sees a riskier one might still be willing to accept.

These bookends tell us the range at which a rational buyer can actually purchase your business and still make a reasonable return on their investment.

The Simplifying Assumptions

To run the simulation, we make a few simplifying assumptions. We don't strictly need to make these, but for the purpose of this explanation they simplify the whole exercise.

First, the buyer holds the business for five years. Not because every buyer sells after five years. It's simply a standard assumption, very typical in industries like private equity, that gives us a defined window over which we can simulate the investment.

Second, earnings stay flat. We take the business's SDE and hold it constant over the buyer's investment period. A buyer is very likely to take a conservative approach when valuing your business; they may not want to pay you for growth that isn't locked in, or growth they have to go out and create. There are plenty of situations where applying a growth rate makes a lot of sense, but for the purpose of keeping this simple, we'll assume it stays flat.

Third, the buyer sells at the end of the period for the same multiple they paid. If they bought it for three times SDE, they sell it for three times SDE. Since we're also assuming earnings stay constant, this means the purchase price and the exit price are the same. Again, deliberately conservative. We're not making any judgment about appreciation in the valuation multiple over the holding period.

Fourth, the buyer pays cash. That means no borrowing to finance the purchase. In the real world most buyers finance a chunk of the price through an SBA loan or similar. But keeping the model all-cash lets us look at the return the business itself generates, before any financing decisions come into play.

Are these assumptions conservative? They absolutely are. But remember whose shoes we're stepping into. The buyer isn't trying to model a dream scenario. They're asking: if I buy this business and nothing improves, do I still earn a reasonable return at my purchase price? If the answer is yes, they can do the deal with more confidence, and anything they improve is upside on top of that.

One Final Adjustment: Capex

One final adjustment before we run the numbers. The buyer doesn't actually keep every dollar of SDE the business generates. Some of it has to be reinvested back into the business each year to do things like replace equipment as it wears out, repairing trucks and mowers, replacing machinery, and so on.

That reinvestment has a specific name: capex, short for capital expenditure. So annual cash flow to the buyer is approximately:

Annual cash flow ≈ SDE − annual capex

Back to the Landscaping Company

Let's bring back the landscaping company from Parts 1 through 3. Recall that it generates about $300,000 annually in SDE. Let's also assume it spends about $20,000 per year on capex to replace worn equipment. $300,000 minus $20,000 gives us about $280,000 of annual cash flow accruing to the buyer.

Running the Numbers

Here's what a very simplified version of the simulation looks like when a buyer builds it out. There's a line for SDE, the capex line we spoke about, and a line capturing the purchase and sale price of the business.

The buyer pays $700,000 on day one, collects $280,000 per year while they own the business, and at the end of year five sells it again for $700,000, the same as what they paid. If we drop those cash flows into Excel and ask it to calculate the annual return on investment, we end up with an annual return of about 40%.

The Shortcut Math

Here's the cool part. You don't actually need a complicated spreadsheet for this. Because of the simplifying assumptions we made, the model collapses into one line of math:

Annual return = annual cash flow ÷ purchase price

You can check that against the spreadsheet: $280,000 of annual cash flow divided by the $700,000 purchase price gives us about 40%.

And if you flip the formula around, you can solve for the purchase price that gets a buyer their target return:

Purchase price = annual cash flow ÷ target return

What Return Does a Buyer Actually Need?

So what kind of return does a small business buyer actually need to make the purchase worth their while? In my experience, and this is consistent with how buyers and their lenders assess these transactions, the typical target for these types of small business deals is anywhere between 25% and 45% per year.

That obviously sounds high, but remember their alternative is to park the money in an investment account and earn something like 8% per year without doing very much or taking on a huge amount of risk.

A 25% return is usually more relevant for a stronger, more stable business, perhaps one with contracted recurring revenue, a real team, and less dependence on the owner. A 45% return is more appropriate for a riskier one, smaller, more owner-dependent, with volatile earnings and some customer concentration. Buyers make their own assessment of the risk in order to come up with their target return.

Running Both Bookends

Let's run both ends on the landscaping company.

If the buyer views it as a relatively low-risk investment and is willing to earn a 25% return: $280,000 ÷ 0.25 = $1.12 million.

If instead the buyer views it as higher risk and requires closer to a 45% return: $280,000 ÷ 0.45 = $620,000.

Buyer's view of risk	Target return	Price they can pay
Lower risk / stable	25%	$1,120,000
Mid-range	37%	$750,000
Higher risk	45%	$620,000

So there are our bookends. Depending on the relative risk associated with the business, the Returns Approach says a rational buyer might pay anywhere between $620,000 and $1.12 million for the business.

Cross-Checking Against the Market Approach

Remember that the Market Approach in Part 1 valued this business at $750,000 based on what similar businesses had sold for. Notice that $750,000 sits very comfortably within our bookends. That's an important check. It tells us the market price we're seeing is one a buyer can rationally pay. In fact, $750,000 would earn a buyer about a 37% return, right in the middle of the 25% to 45% that buyers actually need.

Now imagine we had instead priced this business at $1.5 million. That's outside the bookends, and at that price the buyer's return drops to somewhere around 19%. Unless the business is exceptionally high quality—in other words, low risk—that's not a return that's likely to work for most buyers in the small business space.

So in reality we're not using the Returns Approach to land on a single number. We're using it to pressure-test our asking price from the buyer's perspective, and to establish a reasonable asking range in which a deal could realistically happen.

Where the 2 to 4 Times Rule Comes From

Now here's the payoff I promised at the start. If we take those two target returns and flip them into multiples: 1 ÷ 45% is about 2.2 times cash flow, and 1 ÷ 25% is exactly 4 times cash flow. That's where the 2 to 4 times comes from.

The rule of thumb everyone talks about isn't a coincidence. It's the mathematical consequence of buyers typically looking for a 25% to 45% return to make owning and buying a small business worth the risk and the work. Riskier businesses price closer to 2x; stronger businesses price towards 4x.

Why This Matters to You as a Seller

There are three reasons I think this is important.

First, it gives you a great reality check on your asking price. You can run this math on your own business in about two minutes. Take your SDE, subtract your annual capital expenditure, and divide by your asking price. If the result comes out below 25%, that's a sign most buyers, and probably their lenders, are going to pass at that price.

Second, it can help you justify a higher price. If your business is genuinely lower risk—contracted recurring revenue, a seasoned manager in place, a diversified customer base—then buyers will likely accept a return towards the 25% end of the range. In that case, the exact same cash flow supports a meaningfully higher asking price. That's the difference between a business valued at two times earnings and one valued at four times. It's also the reason the work you do in advance to de-risk your business before you put it up for sale will pay for itself many times over.

Third, it helps you understand how a buyer is thinking at the negotiating table. When a buyer pushes back on your asking price, they're usually not trying to be difficult. It's more likely the math isn't clearing the return they need. If you understand the model, you can negotiate the inputs to their calculation. You can talk about the risk story, the add-backs, and the deal structure, instead of just arguing back and forth about a price.

And that's exactly why, when I value a business at Sundance, I don't rely on a single method. I pull actual transaction data from my databases, I run the returns model, and then I lay everything side by side to see where there's overlap. When the values across different valuation methods start to converge, you can price the business with a lot more confidence.

Wrapping Up the Series

Let's quickly wrap up the full valuation series.

• Part 1: the Market Approach, which looks at what other similar businesses have recently sold for. For most small businesses, this approach does all the heavy lifting.
• Part 2: the Income Approach, which assesses a business's value based on the present value of its future free cash flows. Less commonly used for smaller businesses, but it's the theory that underpins every valuation method.
• Part 3: the Asset Approach, based on the sum of the values of the individual assets owned by the business. This typically gives you a floor, as it often discounts or overlooks the business's value as a going concern.
• Part 4: the Returns Approach, which gives us insight into how buyers really think about the purchase price, and a valuation range based on the prices at which buyers can reasonably pay and still earn a reasonable return.

Understanding all four of these valuation methods will help you have much better conversations with business brokers, lenders, and, most importantly, with buyers on the other side of the table.

What's Next

In my next video, I'm going to pull out a real tax return and show you how to calculate SDE from it, line by line. SDE, if you recall, is the number at the foundation of almost everything we do in this series.

And if you're seriously thinking about selling and want to talk through your specific situation, including what the buyer's return math looks like at your target price, I offer a free, no-obligation consultation.

Again, I'm Ed from Sundance Financial, and I'll see you in the next video.