The valuation of a business––the true worth of your business––is affected by a number of factors which can either increase or reduce the benchmark value as provided by the ValueMyBusiness-RMIT Index of business multiples.
The Index is an earnings multiple is calculated for businesses across 19 industry classifications. However, the factors below impact on value in a positive or negative manner.
The factors that can affect value are:
Type of Income
While a dollar is a dollar, when it comes to assessing a business, different income sources have different values. What potential owners are looking for is some assurance that this year’s income can be repeated or improved into the future. Some professional private business investors refer to two distinct types of income generation activities as hunting and farming.
- A hunting business is reliant on hunting for new business, often either one off activities for the customers, or project related work. In these businesses the business development (sales) team will be continually presenting proposals or quotes for work and winning a proportion of them. Consultancies are typical hunting businesses.
- A farming business is reliant on growing its revenue by nurturing a customer base. In this case the customer base may be defined by geography, or by repeat purchasing behaviour. In these businesses reputation and customer service are very important and customer orders walk into the organisation. Retailers are typical farming businesses.
Profit margins are an indication of the level of demand for a service, as well as the strength of the competition a business faces.
- A low margin business has a reduced margin for error, and therefore a higher risk. Margins could also be an indication of industry life cycle – at the start, the margins tend to be higher. They begin to tighten as the industry matures and becomes more competitive, and towards the end of industry cycle, where there is considerable industry consolidation, margins stablise reflecting the changing and reduced competitive landscape.
- A potential owner of a business is buying its future not its past and as such there is a high degree of uncertainty. A business with a long and steady track record is a potentially more reliable generator of future income than one that has just started in the same industry. As such it may be valued at a higher earnings multiple.
- Earnings stability can be greatly influenced by external factors as well. For example, agriculture can be affected by weather patterns, while import and export business can be affected by currency fluctuations; alternatively, some tourism businesses are very seasonal.
The value of a business is greatly enhanced when the barriers to entry are high or the business has a competitive advantage.
Capital intensive industries, for example, such as the mining of iron-ore or the manufacturing of commercial airliners, are two industries where the costs of entry are so high that few choose to enter.
A competitive advantage for a business lies in:
- The Intellectual property that it owns or has the rights to. Examples would be patents, trade secrets, copyright and trademarks, e.g. pharmaceuticals earn monopoly profits on their medicines while the patents are in force and generics are kept out.Having a dominant market position, where the rules of competition are highly influenced by being the market leader –– increases revenue and margins, e.g. Telstra before the NBN.
- Strong commercial supply relationships where the business has an enhanced bargaining power over suppliers––leads to lower input costs, e.g. supermarkets,
- Cost advantages over its competitors – giving it greater flexibility in making a profit regardless of the market price, e.g. BHP – the lowest cost producer in the world and so makes a profit when others can’t.
- Product differentiation – where the product is perceived to be so different to that of its competitors that customers pay a premium to buy it – power over buyers e.g. Apple’s iPhone.
- The general rule is if a business has a competitive advantage, it is worth far greater than one that does not.
Getting into an industry early in its lifecycle provides a business with the potential to capitalize on a rapidly expanding market. It also runs the risk of the unknown, and the possibility that the potential market has been massively overstated.
At the other end of the lifecycle, businesses in declining industries may have limited opportunities for growth, although the lessening of competition may, paradoxically, stave off the inevitable demise and result in stable income, which may be attractive to certain owners and investors.
In between there are mature and consolidating industries in which the big tend to get bigger, and a key question for business owners is whether to grow (often through acquisition) or get out (often through trade sale).
Each lifecycle stage will be regarded as having more or less value to different investors. As such it represents a factor that affects the earnings multiples applied to a particular business in particular industries, as perceived by the potential owner or investor.
Reliance on Owner Operator
Many SME businesses are reliant on the owner operator. This can affect the value by the extent to which the business relies on the owner to operate:
If, for example, the business is reliant on the owner’s personal relationships forged over many years, a new owner may find it difficult to step into the role and run the business and justify the high asking price. The inevitable consequence:
- is loss of custom, which affects income, or
- having commercial relationships which are less favourable than were previously negotiated, which affect the cost structure of the business
Ultimately they have an adverse effect on profit.
As such the value of a business will be highly subjective, and the departing owner operator is in a difficult position. The business owner needs to show that she has a well-run business with a good reputation while at the same time present the business as having the potential to be run better and go further with the new owner.
Where there is a high level of owner reliance, the best strategy would be to prepare the business well in advance of selling it, so that owner reliance is minimised by:
- Delegating to existing trusted employees,
- Employing the right people to take over the roles
- Documenting and putting in place the operational systems, procedures and practices to ensure the business continues regardless of who owns it.
As a general rule of thumb, the less a business is reliant on the owner operator the higher the value of the earnings multiple.
The market of buying and selling of businesses fluctuates over time. Some businesses are hot while others are to be avoided. For example, changes in legislation can encourage or discourage investment in particular industries. On the other hand, changes in society or demographics will also impact on the demand for particular businesses.
Australia is moving into a major demographic change, particularly among business owners, with the baby-boomers moving into retirement. The volume of businesses coming onto the market is forecast to grow significantly affecting the supply-demand equation, and thereby affecting price.
This article originally appeared on the previous owner’s version of this website and was not created by the new owners.