The business of small business valuation

By Kobus Oosthuizen

Businesses are valued for different reasons and the method applied in determining the value will largely depend on the reason for the valuation.

Buyers, sellers, franchisors, brokers and banks may all be interested in the value of a particular business, but as the reasons for their interests differ, all are likely to arrive at different values.

For the purpose of this article, let us assume that you are the business owner and are desirous of selling. You will need to establish the value at which you are going to put your business on the market.

The most common method employed in business valuation, is to apply an earnings multiple to current profit and then make certain adjustments depending on circumstance. This method, also referred to as the price earnings method, implies that the value of a business is primarily based on the aggregate of the profit anticipated over a certain period.

Gross valuation = current profit x earnings multiple

Current profits

If the management accounts of the business have been maintained regularly and contain sufficient detail, determining the current profit is a fairly objective exercise. In calculating the value of the business it is prudent to use annual profit or an average monthly profit for at least a period of six months, rather than using only the last month or two. It may happen that a marginal business generates special attention for a limited period through the operator’s personal efforts and some additional marketing expense, resulting in a “spike” in business income.

If the price earnings valuation method is applied in determining the selling price of a business, you are in fact “selling” the value of your future profits. It is necessary therefore to question whether the current performance levels can be sustained over the next two or three years.

Although the profit in the last two months are more important in relation to the profits in the prior months, there may be isolated circumstances contributing to higher or lower profits in recent months. Using profit numbers for a period of less than 12 months ignores the effect of seasonality and is not advisable in an industry with cyclical tendencies.

Before making calculations based on the net profit, the income statement for those months should be “cleaned out”. Ad-hoc income and expense items that are likely to re-occur, such as maintenance costs, should be adjusted to an average over the period, while such items as penalties or grants that are unlikely to re-occur, should be ignored for the purposes of the calculation.

Earnings multiple

The earnings multiple, in principle, indicates how many months profit a business is worth selling for. Differently put, how long will the business have to operate at an assumed level of profitability in order to repay itself? The value of the business at the end of the “self-repayment term” is the upside for the buyer and rewards him for the risk he took in accepting the assumed level of profitability.

With a myriad of factors impacting the decision on what earnings multiple should be used, reaching a decision is more an art than a science. As the earnings multiple number has such a significant effect on the valuation outcome, it is justified to provide sufficient supporting arguments for the specific multiple used.

A high earnings multiple is indicative of the fact that the buyer is taking less risk and that there are fewer factors with the potential to derail the future profitability assumptions. A low earnings multiple means the opposite, but may present a more lucrative investment for the buyer.

Gross valuation

This number is arrived at by multiplying current earnings with the correct earnings multiple. Circumstances may require adjusting the gross valuation in order to arrive at a net valuation. The net valuation is the figure used in the agreement between the buyer and the seller.

Certain soft issues, such as urgency of the parties and the funding position of the buyer may impact the extent of the adjustment between the gross and net valuation.

In coming articles we will further investigate the soft issues influencing the value adjustment and the extent of their impact. We will also touch on the different valuation models used and their suitability in small business valuations. □

Kobus Oosthuizen, after having qualified as a Chartered Accountant in 1992, becomes one of King Pie’s first franchisees. In 1996 he co-founded and managed the Butterfield brand until 2005 when it boasted 120 franchised bakery outlets and also received FASA’s Franchisor of the Year award. Kobus served as the Chairman of the FASA until 2009 and founded SA Franchise Warehouse thereafter.

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