RETURN ON INVESTMENT

You are presumably looking to buy the business on the assumption that it will make profits which will provide you with a return on your investment. In addition to IRR above, this return can be expressed as a simple percentage. So if you pay £1 million and expect it to generate earnings (i.e. profits) of say £200,000 a year, then your anticipated return on your investment is £200,000 ÷ £1 million = 20%.

Reversing the formula (£ 1 million ÷ £200,000) also gives the P/E ratio referred to above.

These values can also be used to express an indication of risk by way of the payback period. Assuming that earnings will continue to run at £200,000 per year, the payback period in this case (i.e. the period it will take until the original investment has been paid back) is £1 million ÷ £200,000 or five years. Obviously the shorter the payback period, the quicker the purchaser will be ‘seeing his money back’.

Of course none of the above take into account the cash implications of the deal (such as capital expenditure, movement in working capital, etc.), in the way that discounted cashflows and therefore IRR does. They are therefore more crude measures, but as they are easy to express and easy to compare against returns on another investment, such as simply leaving your money in the bank, they are widely used by purchasers.

SECTOR SPECIFIC

Many trades, particularly those where there are a relatively large number of small businesses with therefore many sales during any business year, tend to develop their own specific basis of valuation and normal deal structure.

For example, you will often see a professional firm such as solicitors or accountants sold on the basis of a multiple of gross recurring fees, while valuation of a hotel will be a function of room rate, occupancy rate, and number of rooms; restaurant valuations will be driven by numbers of covers; and pubs by barrelage.

Brokers in these areas of business will often express a valuation in terms of these key metrics. So, for example, brokers dealing with residential care homes will often express a value in terms of £X per bed for comparison purposes.

Standard bases for valuation and deal structure

As a result, fairly standard bases for sales valuation may grow up, such as: ‘For business type X, the sale value is likely to be twice annual gross sales plus the stock, furniture and fittings at cost.’

In addition, there may also be fairly standard approaches to structuring a deal. This is particularly applicable to small service or professional businesses where as discussed at the end of the last chapter, the value of the business often lies in the personal contacts and network of the existing owner of the business. If you are interested in buying such a business you firstly have to make an assessment as to whether there will really be a business once the principal has gone. Assuming that you believe you can manage the business after the old owner has gone, you then have to consider how far the business’s earnings will be reduced by their departure and how you can best manage this to minimise the damage.

In these circumstances, a payment spread out over a period of years based on expected earnings is not unreasonable. It is also usual for the old owner to stay on as either an employee or a consultant for a period of say, one, two, or even three years, in order to ensure a smooth handover of the business and the contact base to the new owner, with a payment being structured as some form of an earn out.

EARNINGS MULTIPLES

The most commonly used basis of valuation in dealing with small owner-managed businesses is the multiple of earnings approach.

This is calculated simply on the basis of:

• earnings/profits (before interest and tax, known as EBIT or PBIT)
• times the appropriate multiple.

The level of multiple to be applied is then obviously a matter of judgement, given the strength of the business and the current economic circumstances. If, for example, you were looking at an established manufacturing business with a good market position and established management team you might expect the seller to be seeking a multiple of say five to seven times current earnings.

Obviously, the worse the competitive position or reliance on strong management, the lower the multiple that should be expected. The clearer the competitive advantage and steadiness of the earnings stream, the higher the multiple that would be sought.

WHAT YOU SHOULD NOT PAY FOR

It is evident from the above that earnings, both current and future, are crucial to almost every business valuation whether in terms of profit or cash. So earnings, current and future, are the starting point for both you and the seller to consider valuation. This reinforces the point that the seller needs to be able to demonstrate to you the business’s real earnings potential, by pointing to demonstrable profits and earnings in the business, and that these should all be clearly and demonstrably flowing through the business’s books.

Do not fall into the trap of in effect paying for the benefits you are going to bring to the business. It may be that you are confident that you can grow the business’s turnover from £1 million to £3 million and earnings from £100,000 to £500,000. But if this value will only arise as a result of the work that you have to do on the business once you have bought it, why should you pay the existing owner for it?

Remember also that turnover, as such, does not have a value. Turnover is only a tool to generate profit and it is the profit that the business generates as a return on your investment that has a value for you.

SUMMARY

The business’s value is only what somebody in the market is prepared to pay for it, it is not some real value set in stone. And what buyers in the market are prepared to pay for is a return on their investment in the form of future streams of profits and cash. The only question therefore is how much money you and other buyers are prepared to pay for that future income given its apparent degree of risk or reliability.

In summary, the basic methods of valuation and their pros and cons are as follows: