Factors Affecting Value

In property, the generic valuation guide is dollars per square metre for various neighborhoods, but other factors need to be considered when assessing an individual property. In business the generic valuation guide is the earnings multiple for industries and business size.  However other factors need to be considered when assessing an individual business.

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 of 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 organization. Retailers are typical of farming businesses.

Typically the earnings multiple on a farming businesses will be higher than on a hunting business for smaller businesses.  However this changes with scale as a larger hunting business is considered to be more likely to be able to continue to generate the income, while a farming business may be considered to have little room for growth.

Profit Margins

Profit margins are an indication of the level of demand for a service, as well as the level of competition the business is facing.  A low margin business also has a reduced margin for error, and therefore a higher risk.  Trends in margins are also an indication of life cycle – at the start of a life cycle the margins tend to be higher, these are reduced as the industry matures, and become very competitive as the industry consolidates – an example of this is mobile telephony.

Stability

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.

Stability may also be an external factor.  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. 

Competitive advantage

In management schools they often talk about barriers to entry. The key concern of the potential owner in this regard is what is stopping a competitor doing what I am doing and eating into my customer base and income streams.  The importance of this will be very industry specific, and can often be misconstrued.  Sometimes having a similar business setting up next door can be good for business – restaurant districts and farming districts are good examples of this.  However as a general rule of thumb, having something that is difficult to replicate adds value to the business.  Two key examples are:

• Market Position – this could be as simple as where is your advertisement in the Yellow Pages? A common mistake made by owners looking to sell a business is to reduce their advertising.  Tragically this could unwind a 20 year investment in establishing a high-profile position and subsequently devalue the business.
• Customer Loyalty – once again this is a valuable asset that should not be messed with in the lead up to a sale.  If you have a remote business, such as plumber, electrician or other home service type operation, then keeping your contact points consistent is very important and these also need to be part of the transfer to the new owner.  Included in this list of contacts are phone numbers, regular advertising placements (it is surprising how many existing clients still contact businesses by looking up their advertisements), referral partners and other lead sources.

Industry Lifecycle

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 terminal futures, but the lead up to the end can be very profitable as the competitions disappears allowing margins to increase.
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 particular business in particular industries, but one without a consistent application.

Reliance on owner operator

Many SME businesses are reliant on the owner operator.  This can affect the value in two ways:

1. If the business is reliant on the owner operator, then it limits the potential owners to those that possess the key skills required by the owner operator.  They will bring with them a perception of the value difference between their skills and those of the current owner operator.  As such this value will be highly subjective and the departing owner operator is stuck between a rock and a hard place.  He needs to show that he has a business that is well run with a good reputation, at the same time as presenting a business that has the potential to be run better and go further with the new owner.
2. If the business is not reliant on the owner operator, then it limits the value a new owner may be able to bring to the business, and therefore the perceived increase in earnings.  However it also broadens the number of potential owners, and the perceived reliability of the business.

As a general rule of thumb, the less a business is reliant on the owner operator the higher the value of the earnings multiple.

Market Fluctuations

The buying and selling of businesses creates a market with the demand for different types and sizes of businesses fluctuating over time.  For example changes in legislation can encourage or discourage investment in particularly industries.  On the other hand changes in the 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.  This is predicted to bring an increasing number of businesses into the market, with an estimated 44% of businesses to be sold in the next 10 years.