By Christo Weideman
Christo Weideman is a seasoned banker with extensive franchise experience. He is also a Business Associate at Global Business Holdings and a member of the South African Council for the Property Valuers Profession.
In continuation of the previous article. The parting essential component was that the buyer acquires future profits. The question now is: How do profits lead back to an acquisition price?
A profit multiplier is often used in the process of attaching a value to a businesse, more often than not in the franchise space. As a general rule of thumb, the average monthly net profit achieved is multiplied with a factor from 24 to 36. This factor refers back to months. So this means that using the multiplier, the average net profit achieved, should add back to an amount very close to what was paid for the business in the first place. The owner therefore recoups the initial investment over a period of 24 – 36 months. Again, this factor is linked to the goodwill, value of the brand, the location, the costs to revamp (if required or already done), and importantly how effective the business is managed. This multiplier is sometimes confused with breakeven turnover. Breakeven turnover is the turnover that should be achieved to cover all the expenses of the business. The time taken to achieve breakeven turnover is normally between 15 – 18 months.
An example to explain the net profit multiplier.
Let’s say the average net profit of a business is R45,000 per month. The business was acquired for R1,500,000. If the net profit is divided by the acquisition price, it results in a number of 33,3 . This means that the owner will recoup the initial investment within a period of 33,3 months. Please bear in mind that this number cannot be used in isolation. It is recommended to look at what the average factor used in the industry is. This is a way to cross-check the accuracy of the number and refers back to a common method used in the industry referred to as comparable sales or market sales.
Other methods of business valuation
A number of articles have been written about the methods of valuation for businesses. The discussions will not be repeated, but as a reminder common methods used are:
- Market approach or comparable (recent sales) method. This method is often used for residential and commercial properties where information is available. This method uses identifiable reference points such as size/income per square meter.
- Income approach or often referred to as discounted cashflow analysis. This is appropriate for income generating entities, for example a commercial property with lease agreements. It is also used for businesses during the sale of a going concern. Because not all businesses are equal in all aspects, it is reliant on verifiable financial statements.
- The cost approach looks at what it cost to establish the business or property in the first place and if it had to be replaced. It is often used to get to a replacement value for insurance purposes.
What about the turnover–based multiplier effect?
A number of businesses, especially in the retail space, use multiples of turnover to determine a price. Remember, this multiplier is used as a rule of thumb to quickly get to a pre-determined value. This is however only an indicative price. All the methods and factors discussed above could have an influence on the actual price. Just to recap, it will be the location, age of business, whether it was revamped recently or in dire need of a revamp, the rent levels, and most importantly whether it is a going concern or not. If it is not trading, it is not a going concern.
Willing buyer, willing seller
There are many more methods such as return on investment, payback method, price-earnings multiple or even extra-earning potential. The methods used will have differing answers and all depend on why it is done, by whom the value is determined and how it is done.
Just remember. The final price paid is established through negotiation between a willing and able buyer and a willing seller.