Frequently small business are valued by common – but unreliable formulas that at best are “rule of thumb” procedures. These conventional yardsticks are convenient to use due to their simplicity, et each falls short as an accurate valuation method because they do not adequately consider valuation in terms of earnings.
1). The Sales Multiplier Approach: Every industry appears to have a rough formula which somehow translates sales into an approximate valuation. Supermarkets, for example, are supposed to be worth inventory plus one month’s sales. Luncheonettes and small restaurants are popularly prices at 3-4 month’s gross. Drug stores, according to industry averages sell for 100 day’s sales.
No sales multiplier can establish the value of the business because it only measures sales with a curious disregard for profits.
The sales multiplier can make sense if the profit of a business is always proportionate to its sales. But that is seldom the case. Examining any number of small businesses will show little correlation between size and profit. Some businesses show substantial sales and losses, while the small volume enterprise may have a solid history as a profit producer.
Sales can be an important factor in valuing the business, but only when the buyer can project expenses falling into line to produce proportionate profits. Without that projection, the sales multiplier remains a faulty valuation technique.
2). The Comparison Approach: Valuations are often nothing more than an attempt to compare the target business against prices asked for comparable businesses. This is not necessarily a wrong approach because the value of any commodity is largely based in relation to comparable items. And because market conditions can certainly influence value, it is suggested that both the buyer and the seller have a clear idea of what competitive businesses are readily sold for.
The difficulty with the comparison approach is that unlike most other commodities, a business does not lend itself to accurate comparisons. As an economic entity there are too many variables. Since earnings are dependent on the individual characteristics of the business – volume, expenses, loan terms, competition and potential – even within a given industry few businesses have sufficient points of economic similarity to allow credible comparisons.
When comparisons are made, the comparison is likely to focus on sales, making the approach somewhat similar to the sales multiplier. This may not be so with buyers who may have had ample opportunity to investigate the total financial affairs of other ventures, but it will be so with sellers who will only know a competitor’s sales and selling price.
Franchised businesses may be one exception to the rule. Franchising is based on a high degree of conformity and franchised operations showing near equivalent sales should show near equivalent profits, as margins of profit, expenses and other operating characteristics should conform to chain standards.
3). The Asking Price Approach: Another common but mistaken approach is the belief that value relates to the seller’s “asking price”. It may from the seller’s viewpoint, but seldom from the buyers.
Unwary buyers use the asking price as an arbitrary threshold from which to bargain. Many a buyer believes that if he or she can reduce the asking price by 15-25% he has suddenly found “value”.
Buyers should not assume that the seller’s asking price has any rational relationship to value. A seller is the least qualified person to determine the value from a buyer’s perspective. With years of psychological attachment to the business and the obvious self-serving benefit a high price would bring, the reality is that 90% of all small businesses are overpriced. After the business sits unsold for a year or two, the seller may gradually drop the price until it finally enters the reality zone, approximating its true value.
Rather than start at the top with the seller’s asking price, the buyer should assume the business has no value, qualifying every dollar against the profit potential of the business.
4). The Asset Valuation Approach: The most common method for valuing the small business is to place a value on the various assets being sold. This is particularly true with retail operations and non-service ventures whose assets are primarily tangible in nature.
A seller, for example, may suggest his business to be worth $1,000,000 based on a $50,000 inventory at wholesale cost, $25,000 representing the replacement of fair market value of fixtures and equipment and $25,000 for the goodwill. Of course, if other assets were to be sold, these assets would be valued and added to the price.
Valuing a business by the sum of its assets has its limitations. The tangible assets can be accurately appraised. Inventory can be precisely tabulated at its cost price and the approximate replacement value for fixtures and equipment can be ascertained through outside appraisal or market prices. The distortion then is comparing a value for the illusive goodwill – the intangible asset that is incorporated into most small business valuations.
Frequently, the value placed on goodwill is equal to or greater than the tangible assets combined. The validity of the total price is then dependent on an accurate appraisal of goodwill as a component of the sale. Since goodwill represents nothing more than an expression of the profitability of the business, the buyer is still forced to develop a profit orientation when this approach is employed.
The business selling for the value of its tangible assets alone does not represent an easier situation. A seller may bargain, for example, to sell a retail business for the cost value of inventory and replacement value of fixtures. But what are those assets really worth if they cannot be used to produce future profits? Without the profit potential, these same assets are worth only their liquidation values.
5). Book Value Approach: The “book value” is an accounting term that reflects the owner’s equity in the business. If the total liabilities are deducted from the total tangible or real assets (excluding goodwill), the difference is what the business is worth on the books. Frequently, larger companies are sold through a transfer of corporate shares for their book value.
There are, however, two problems in using this figure to determine the value of a smaller business. First, it does not take into consideration the profitability or earnings potential of the business. Further, the fixed assets (real estate, equipment, etc.) are shown at their depreciated value rather than their fair market value and there can be a considerable difference between the two to distort valuation.
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