Profits Up - Business Value Down

If you are in business then there’s a good chance that at some point you have probably wondered, what is my business worth?

Impact of future profits on business value

You have probably also have some figure in mind of what you think it is worth, right? So how did you arrive at this figure? If you are like most, you are likely basing your valuation on some form of industry average multiplier, rule of thumb or crude comparison of a similar business sale that you know about? You might have heard things like in my industry businesses generally sell for 1 – 2.5 x net, or 10 – 14 x weekly sales, or $ for $ with revenues… There are hundreds of examples of these types of “rules of thumb” that get thrown around and all go some way to misleading the business owner of the reality of their specific situation.

The problem with these simplified valuation methods is that they assume the value of your business is going to be the same as the average. All methods also use specific metrics such as PEBITDA, EBITDA, EBIT or Net, etc. Does the average punter who uses them really know how to apply them properly? In my experience of valuing hundreds of businesses, the resounding answer is no, not even close! Further to put these metrics into perspective consider the following example.

A “rule of thumb” for coffee shops operating 5 days a week is that these types of businesses will sell for between 1 – 2.5x net. So what does this mean? The rule asserts that if you have net profits of say $100K per annum that it will sell for somewhere between $100K and $250K. That’s a pretty wide valuation range! If you owned a coffee shop would you be happy to accept $100K on sale knowing that you might have sold it $250K? How do you negotiate when you don’t understand where you sit in range? Is the range correct anyway, after all these are just averages? What if I have something special that a buyer is prepared to pay for, surely my business is worth more? Does my business have strategic value? Maybe it’s the CBD location, coffee beans or special chutney sauce that sets your business apart from the rest and keeps your customers lining up out the door. Maybe your systems and business model has franchise potential or maybe it’s your customer loyalty program and legion of Facebook fans that can’t stop raving about the way you do things.

The reality is that all individual businesses, their owners and their buyers are all highly unique and the price that one similar business sells for is at best only indicative of the value of another business and a large number of factors need to be carefully considered when drawing comparisons between one business sale and another business. The actual sale price of two seemingly comparative businesses can be dramatically different and the simple truth is that reliance on these basic valuation approaches leads to most business owners being genuinely surprised by the true value of their business, some for the better but mostly for the worse.

Just like public listed companies on the ASX, private business value is never static and is also in a constant state of flux. Don’t assume that just because your profits were the same as last year that your business value is the same.

In fact one of the key drivers of business value is some form of measurement of future profits not historical. This is because future profits represent the mechanism for the payment of dividends and subsequent repayment of initial acquisition investments. There are many examples on the ASX of how downgrades of profit forecasts directly and negatively impact the trading price of the equity. The same applies to for private business valuations.

Many business owners are surprised to learn that even as their profits go up, their business value may actually be heading south. This is because business value is impacted by a large number of factors outside of just profits. For example despite rising profits, your business value may be in decline as a result of factors such as;

  • Diminishing market share or accessible market;

  • Maturity of the product or service life cycle;

  • Declining differentiation or increasing competitive forces;

  • Loss of protective moat (patents, trademarks, copyrights, domains, territory);

  • Dissatisfied customers;

  • Diminishing growth or earnings potential;

  • Decreasing remaining term of lease, franchise agreements, etc

  • Required capital commitments / replacements;

  • Bad debts or negative cash flows;

  • Changing revenue mix;

  • Increasing dependence on key suppliers, employees, customers;

  • Increasing dependence on the business owner, etc.

If you plan to sell your business one day and use the proceeds to fund your retirement, grow a valuable business, or start a new venture you owe it to yourself to understand what the real value of your business is right now and how your business value is impacted by each of the business value drivers. Knowledge is power.

To accurately determine the value of a business requires a professional appraisal which carefully reviews a wide variety of qualitative and quantitative business attributes. It doesn’t matter if you are buying a business or selling a business, a professional business valuation is an investment which not only provides clarity on your position but can provide you with the ammunition to negotiate a significantly better deal or grow a valuable business over time.

#businessvaluations #rulesofthumb

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