Design & Designer Series: Jeanne Chung
Even if you are not planning to sell, obtain financing or do estate planning in the near term, going though a valuation process will provide insight into maximizing long-term value.
There are many reasons why retailers should know how much their businesses are worth.
It's a necessary piece of information for those who want to formulate a transaction, a transition strategy, or obtain funding. Unlike real-estate assets, retail businesses cannot be appraised based on multiple comparable properties in the same area.
Every retail business is unique. Some are growing, others stagnant, and still others are sliding backwards. The best are supper-profitable, many are so-so, and a small sub-set should just bite the bullet and do a GOB. I've worked with retailers who've cultivated a special niche in their marketplaces and others that do nothing special at all. There are retailers that have zero debt. Some are insolvent. Thus, no two businesses deserve the same value – the circumstances are always different.
There are multiple ways to value a business. Presented here is a simplified method that can be used to provide a range of values for your business. A more formal business valuation report would be much more detailed, including assumptions and explanations behind all the numbers. It might also include alternative valuation methods.
XYZ Furniture Valuation
Let's determine the value of a fictional retailer, presented as a conversation with its owner, Fred.
After many years as a furniture retailer, Fred has decided to explore options for moving on to retirement.
The obvious options Fred identified were to find a buyer or run a big GOB event. He didn't know where to begin, or how much his business might be worth, if anything, to a potential buyer. Fred approached an industry consultant for assistance.
Owner: “Where do we begin?”
Consultant: “First, we need to gather past business performance over three to five years by pulling your Profit and Loss Statements. We will compare your results for sales, minus cost of goods, minus operating costs, side by side, so we can visually see improvements or otherwise."
Owner: “Well, if you look at my profit, it isn't that great. I took a bunch out of the business and, of course, had to pay taxes.”
Consultant: “That is why we must do a normalization, also called seller discretionary earnings. This calculation adds back all monies taken out of a business in the form of owner payroll, vehicles, other expenses, depreciation and taxes. We will also make sure any rent paid to other closely held corporations are listed at fair market rates.
“This is not tax accounting. A normalization shows a prospective buyer what the business might produce without you in it.”
Owner: “Makes perfect sense. So what is the next step?”
Consultant: “After we determine average earnings or net income over the past few years we will apply a multiple to the earnings number.
“Profit and loss
tax for the previous three years, as well as the
period, was averaged and shown in Chart #1.”
"Multiples are published ranges based on the Seller Discretionary Earnings method. We will use a high multiple if your business is profitable, functional, growing, debt free and has very good industry KPI comps. We will use a mid-range multiple if your business turns out to be in the average range. And, if your operation under-performs or is dysfunctional we will apply a low-end value.”
Owner: “OK, but what about all the inventory I own and the cash I have in the bank?”
Consultant: “The next step is to decide what assets and liabilities you plan to leave in the business, then add or deduct the net difference. Most owners sell their business along with its inventory, customer receivables, accounts payable, and possibly other assets and liabilities.”
Owner: “I can live with that. So, is that it?”
Consultant: “Pretty much. I will also calculate a payback ratio to see how long, before tax and any other added expenses it might take for a prospective buyer to pay for the purchase of your business. Investors or buyers usually want to know how long it will take to get money out of a venture or sell it and make a profit. Most buyers expect the time-frame to be about five years. So, in the end we will compare the pay-back period to the final value price range and test where we land.”
Valuation Results For XYZ
Following multiple conversations, running various business reports, meeting with key players and doing several renditions, here is a summarized snapshot of the value opinion draft for XYZ Furniture.
P&L Chart: Profit and loss performance before tax for the previous three years, as well as the current annualized period was averaged and shown in Chart #1. The calculated average sales for the four periods was roughly $9.45 million with a 50.5 percent average margin. Operating expenses averaged over 46 percent of sales, and after other income, the business produced an average of $420,000 per year in net income.
Normalized Net Income: In Chart #2, we adjusted for expenses that would not be transferred in a sale, or would be different following a sale.. Here, average owner compensation, depreciation and costs associated with the owners' automobiles were added back to net earnings. Since this business owner paid himself above market rate rent, the rent expense was adjusted.
Earnings Multiplier Calculation: Chart #3 shows that after the normalizations, average annual earnings was about $1 Million or 10.5% net income.
Three multiples were applied (1.15, 2, and 3) based on data obtained from Bizcomps.com suggesting a multiplier range of 1.15 to 1.99. The higher multiplier of 3 was also applied to reflect actual sales in the past year of similar furniture business that sold at about this multiple.
Choosing a multiple range, is an informed estimate. As noted previously, if a business has sales increases year over year, has no debt, and has an owner that can easily be replaced, it should fetch a high multiplier. Conversely, if the business has declining sales, is insolvent or has an owner that is indispensable to the business, the multiple will be at the bottom range.
Assets & Liabilities Chart: After an earnings value was calculated in #3, further adjustments were made to account for assets and liabilities to be transferred. In Chart #4 additions are made for $2.1 million worth of assets, including receivables, inventory and some others. Deductions of $920,000 were made for accounts payable, customer deposits and other current debt. This resulted in net assets valued at $1.18 Million.
Estimated Value After Net Assets: In Chart #5, net assets are added to the normalized earnings estimates after the multiplier from Chart #3, to produce a value estimate range of between $2.3 Million and $4.15 Million. If an owner wants to sell fast, he or she may want to choose a value at the lower end. If there is a longer time horizon and the owner wants to grow the business further, an even higher value may be chosen.
Payback Ratio: Finally, the payback ratio calculation (Payback Years = Investment / Average Earnings per Year) is shown in Chart #6.
For example, suppose the business was sold for $4.156 Million as calculated using an earnings multiplier of three (Chart #3). Using the calculated average net normalized earnings of $992 thousand in Chart #2, payback would be 4.19 years ($4,156,750 / $992,250).
However, if a buyer was OK with a five year payback, he or she might then be OK paying a higher value of $4,961,250 ($992,250 x 5 years).
How Much Is XYZ Furniture Worth?
XYZ Furniture has growing sales, the company is debt-free, its owner Fred is in good health, and his management team can operate day to day without him.
Based on this evaluation, the consultant recommended that he should not sell for anything less than $5 Million.
Going forward he should continue to operate on a strategic level and empower his people to run the day to day. If an offer comes up that is too good to refuse, he will need to make a decision. If not, he should reassess the situation in about a year.
Just about every business owner wants to maximize business net worth, so even if you are not planning to sell, obtain financing or do estate planning in the near term, going though a valuation process will illuminate factors such as growth, profitability, solvency and others that will help you to optimize long term value of your operation.