Valuation Comments

Chilman Coastal

Valuing your business is a fascinating and highly argumentative topic with limitless variations. It is a combination of an art and a science but in the end, commonsense normally prevails if a sale is to eventuate.

Risk and Small Business

The aim of a purchaser is to minimize risk.

Risk and Reward

  • Price is directly related to the risk of the purchaser making money or losing it.
  • The range of returns can be significant.
  • Perceived ‘safe’ businesses like caravan parks, and those with strong Intellectual Property will mostly sell for a lower Return on Investment (ROI). (ROI is the amount of profit earned before interest and tax for every dollar of assets invested).
  • Businesses that are not so safe such as restaurants or a wholesaler dependent upon one manufacturer will sell on a much higher ROI.
  • Most businesses sell on a ROI of between 20% of the total investment (ie. stock, plant and goodwill).
  • ROI assumes that the return equates to the net profit to the owner after appropriate owner’s wages and depreciation have been allowed for, but before interest and tax eg. a business that shows a net return of say $200K pa. (before interest and tax but after appropriate proprietor’s wages and depreciation) may sell on an ROI of 25% ie. the total investment for a purchase would be $800K (including stock, plant, goodwill and an allowance for working capital).

Value

  • Value is in the eye of the buyer – they won’t hand over the money unless they perceived value in the transaction.
  • Don’t try to sell too high – the business mostly won’t sell or generate genuine interest unless it represents fair value in the market place.

Value or Pricing

  • Value should relate to market value, not just theory. Don’t base the value of your business on the “Business for Sale” columns in the local paper.
  • Value or pricing is not an exact science.
  • Experienced Business Brokers will know what your business is worth almost instinctively.
  • The closer the asking price to the market price, the quicker the business will sell (you should bear in mind that the average time from offering the business for sale to settlement is around 6 months).
  • The asking price is merely an approximation of what the business might bring in the market place.
  • The final price is a mixture of many factors such as the terms of sale, the desire for the buyer to buy and the motivation of the seller to sell.

Recasting Financials

  • The presentation of clear financials is paramount.
  • Adjustments to the Profit & Loss are valid so long as they are reasonable and that the buyer is made aware of the adjustments and why.
  • Adjustments may include:

    • Income or expenditure not included in the Trading Statements.
    • Adjustments to or elimination of any non-recurring, extraordinary, unusual or personal items of income and/or expenditure that does not directly relate to the normal trading activities of the business.
    • Adjust Interest and borrowing costs.
    Examples might include the following:

    • Extra income – deduct
    • Interest payments – add back
    • Excessive wages of owners – add back
    • Insufficient wages for proprietors – deduct the short fall
    • Expenses on private vehicle – add back
    • Other personal expenses – add back

We are seeking to arrive at a “super net profit” which reflects a net profit to a business proprietor before interest and tax but after adequate allowance for proprietor’s wages and depreciation.

Methods of Valuing Businesses

  1. Return on Investment (ROI) Method (capitalisation of estimated future maintainable profits).
    • This is the most frequently used method of valuing a small to medium business.
    • Valuing a business using a ROI method is really powerful. Every dollar of profit can mean $2 to $5 of additional business value.
    • The table below shows return on investment (ROI) rates and multipliers.
    Return of Investment (ROI) RATEMultiplierNet ProfitTotal Sale Value (including stock, plant & goodwill)
    20%5$200,000$1,000,000
    33.5%3$200,000$600,000
    40%2.5$200,000$500,000
    50%2$200,000$400,000
    100%1$200,000$200,000

    (Note: Net Profit represents estimated future maintainable profits before interest and tax but after appropriate allowance for owners salaries and depreciation)

    • The ROI rate is determined by the level of business risk. It is critical to determine what the future maintainable net profit is likely to be (Also known as EBIT…Earnings Before Interest and Tax). The ROI rate adopted will vary as risk and market expectations change.
    • The irony of this method is that whilst you are trying to predict future earnings, you are using past information.
  2. Asset Valuation Method
    • This is the least value that the buyer could sell or liquidate the business for. It is probably the lowest value that will be placed on the business.
    • Asset valuation methods are used to determine value when there is no goodwill or when the business is to be liquidated.
  3. Discounted Cash Flow Method
    • The value of the business depends on its future net cash flows, discounted back to a present value at an appropriate discount rate. This is widely used in mining and extractive industries.
  4. Comparable Sales Method
    • This is able to be used if there is sufficient comparable sales data. It should be used in conjunction with other methods in order to fine tune the valuation.
    • As no two businesses are exactly alike, effective comparisons can only be made after careful research – but useful and reliable information can be difficult to obtain.
    • This valuation method is often used to set lower and upper limits.
  5. Rule of Thumb Method
    • This method can be useful in some industries eg. taxis, hotels, accountancy practices, medical practices, rent rolls etc.
    • A multiplier is generally applied to the gross sales figure of the business.
    • The industry may internally accept the method without being so concerned about the expenses.
    • This method is not used so much these days as it is more risky, particularly when industry norms for value and goodwill may be increasingly hazardous in times of change and fluctuating margins.
    • This is often used as a check only.