If you are a business owner, how do you work out the TRUE worth of your business?
The value of any business is tied to many factors, but principally the business’ revenue stream, position in the market place, length of time in business, security of contracts (if any), value/extent/condition/efficiency of plant and equipment, trade marks and other intellectual property, industry trends, EPA issues/legislative, barriers to entry, staff availability, safety issues, and of course, profitability.
These considerations are all taken into account when a Business Broker is asked to determine an Open Market Value (OMV) for the business. An OMV is based upon applying the principles of Risk Premium to the underlying, sustainable earnings (or profit) of a business, and the above factors will all have some bearing on the Risk Premium associated with the business.
The Risk Premium is the excess return required on risky assets (or businesses) that is the difference between expected return on risky assets and the return on risk-free assets.
The riskier the investment is perceived to be, the higher the return that is expected from the investment. An investor in a business is seeking to purchase a future income stream and as the level of risk in achieving that income stream decreases, the risk premium decreases, or, to put it another way, there is a lower expected return on the financial investment made.
Income is also referred to as earnings or as profit. In order to ascertain that there is consistency in calculating income, most Business Brokers will analyse the Profit and Loss Statements of a business because its shows a Net Operating Profit. However, while certain expenses incurred by a business will remain relatively constant under different owners (e.g. wages, rent, insurances, telephones etc), discretionary expenses (such as costs associated with finance, leases, donations and depreciation) will differ from owner to owner, and the Net Operation Profit may actually understate the true extent of the underlying, sustainable profit.
Therefore the Business Broker performs an income analyse to identify all discretionary costs and all benefits associated with proprietors’ earnings. This final income value is termed Proprietors’ Earnings Before Interest, Tax, Depreciation and Amortisation (PEBITDA). (If the business is managed, and the proprietor is not involved on a day-to-day basis, the income is identified as EBITDA (i.e. Earnings Before Interest, Tax, Depreciation and Amortisation).
Simplified business valuations apply a “multiplier” to PEBITDA or EBITDA, and are done by applying a multiple of (generally) one to four times profit to achieve an OMV. Factors involved in determining the appropriate multiple to use are the same as those used to determine a Risk Premium, and in fact there is a direct correlation between Risk Premium and multipliers (or to use the correct term, Capitalisation Rates). This relationship is demonstrated in the table below, which also shows examples of the types of businesses that can attract lower or higher Risk Premiums/Capitalisation Rates.
|PEBITDA (working owner/s)||Examples of Leasehold Business||EBITDA (managed)|
|Cap. Rate||RP||RP||Cap. Rate|
|1.0 x net||100%||High risk, projections only||40%||2.5 x net|
|1.5 x net||66%||Specialist, Trade, Restaurants||35%||2.85 x net|
|2.0 x net||50%||Medium risk, manufacturing||30%||3.3 x net|
|2.5 x net||40%||Wholesale, managed||25%||4.0 x net|
|3.0 x net||33%||Long, well established history||22%||4.5 xnet|
Note that the value of plant and equipment is not generally added to the business value, as it is the plant and equipment that provides the underlying sustainable income of a business and for which a value is being paid. Exceptions arise if the investment in plant and equipment is substantial and ignoring its value would distort the true value of the business.