Weighing the Financials When Valuing a Business

As we have discussed in prior posts, business valuations are an art, not a science. So when the time comes for valuing a business, you need to consider how to weigh the financial reports to determine your price.

While there are no hard rules; the fact is that the most recent past will provide you with the best guess of the near-term future.

Generally, you will want to analyze at least three years of tax returns and company profit/loss statements to determine an average profit level.

It is normal for a seller to alter the weight of each year and arrive at their asking price depending upon how the business has performed in the most recent fiscal period. If sales and profits were up, it is almost a sure bet that they will provide the greatest weight to that period.

Of course, if the past few years have been consistent, then determining what percentage you should allocate to the past one, two and three years, is quite easy.

Personally, I like to use a weight of 70/20/10 percent respectively – meaning take 70% of the recent year, 20% of the one before, and 10% of the statements from three years ago. If however, the most recent year is either unusually high or low, then the scenario may very well be set for a performance-based earnout. In today’s economy, more deals are being done this way, and it makes sense.

Of equal importance, you should be looking at the results of a rolling twelve month period. This means you need to analyze the financials for the twelve months preceding today and compare them to the prior to twelve month periods. The reason you must do this is because if a business is in decline, it may not have shown this trend as of the last calendar or reporting period.

The one area where buyers also need to be cautious is with annualizing financials. For greater clarity, annualizing numbers is when you take a specific recent period (i.e. four month of financials) and simply multiply them by three to get a figure of what the full year will “look like”. The problem is this is really going out on a limb in the guessing department.

I generally will never annualize anything less than a full nine month period. A business can change so quickly and so using a very limited period and simply extrapolating numbers, is a stretch.

When the overall economy gets tough like we are experiencing today, valuing a business becomes a bit more cumbersome. The reason being you have to look beyond the financials to understand what the industry trends may be and also what looming threats may exist that can adversely impact the business in the near future after you take over. For example, the business may doing okay but a number of key customers could be having their own financial challenges and this may only become evident over the next year.

Do yourself a favor and read the Special Report we have compiled that addresses all of the fundamental issues you need to address including valuations when buying a business in today’s economy. You can sign up and download the report at: http://www.diomo.com/tips.html

Comments

[Joe Davis]

As the seller's representitive I price the business based on the most recent year's OCF reasoning that a current price is based on current events. It's not fair to my client if the OCF is going up each year and buyers like to try averaging to get the price down. Have you ever tried to sell a buyer on an average where the OCF is falling each year? Doesn't work and makes them mad. Such folly.

[ZipDrugs Legal Discount Online Pharmacy]

For some industries such as gas stations even looking at 12 months rolling amounts could be misleading as the profits were shrinking as oil/wholesale gasoline prices were going up.

[Richard Parker]

Thanks for the comments folks. Here are my two cent's worth:

Joe - Great comments and so true indeed. That is why heavily weighing the most recent activity is always the most realitic scenario to all parties.

To "zipdrugs" - Thank you for your comments. Perhaps I did not explain a rolling 12 month P & L however, it addresses the exact point you mention since you are able to see month by month to the present day how the business is performing and further can compare to last year to date rather than conducting an analysis over a prior period that may not reflect the business today. There is absolutely no better way to determine the recent trends.

Insofar as the gas station example, it is actually one of the only direct to consumer businesses where the owner can control margins and pass on increases almost immediately. While the credit card companies are benefitting the most from oil price increases and although some gas stations are seeing gross margin percentage erosion, overall, gross margin dollars are not declining. And let's not forget that you take money, not percenatages, to the bank.

The FIFO inventory pricing of the retail and wholesale gas business, plus the ability to immediately pass on any increases, does in fact provide an enormous degree of insulation for the owner operator unlike other business sectors.

Richard Parker

[Zip Drugs Legal Discount Online Pharmacy]

Reason for my gas station comment was the following WSJ article

http://online.wsj.com/article/SB121538602450331005.html?mod=googlenews_wsj

Given current economic conditions which business in your opinion provides better return on investment as well as ease of management
Gas station
Laundromat
Car wash
Anything else you like

Thank you

[Internet Businesses For Sale]

I always look at my clients trailing 12 month revenues and cash flow in comparison to the previous 12 months and the calendar year financials. If a business is growing this is the number we use to base the multiple on to capture the current trend. In the case where it is diving we still use it but average it out with previous year - I had not considered the 70/20/10 rule but I like this approach as it is a fair method of arriving at a more stable cashflow picture long term and should not provoke the buyer to attack the appraisal too aggressively.
Good idea - thx

David Fairley
Websiteproperties.com

[Richard Parker]

David - Excellent comments - thank you. Regarding the 70/20/10 it definitely provides a reasonable and rationale basis for both sides of the deal and most importantly will, in most cases, provide the best indication of the short-term future prospects of the business.

To "zip drugs" - The WSJ artricle is quite compelling. I had seen the piece this week. While there is obvioulsy merit to it, the best part clearly was the advice in the final paragrapgh by William Kosti, the real-estate broker selling the closed Exxon station and two others nearby, when he recommends that "buyers stop trying to run stand-alone gas stations. Add a restaurant or a liquor store, he suggested." It all fits with what I have been preaching for years - there will ALWAYS be a reason not to buy a business. The difference is that true entrepreneurs find the cracks in business sectors and drive tanks through them. By the way, I have seen may comments posted by you here, what end of the business are you in - buyer/seller/broker? I always appreciate your astute observations and I am sure our readers do as well. If you want to buy a gas station, check out our new guide at: www.howtobuyagasstation.com

Richard Parker
www.diomo.com

[Zip Drugs Legal Discount Online Pharmacy]

Richard,

I am a "potential buyer". I am trying to figure out which business type provides good ROI as well as relative ease of management.

I did read the comment about adding a restaurant/liquor store to the gas station. It may make sense for an existing owner who is struggling but not for a new buyer as adding restaurant/liquor store will make new buyer go into restaurant/liquor store not just gas station business.

Therefore it would make more sense for a buyer just to buy restaurant/liquor store since they usually have lower multiples than gas stations.

[Richard]

Dear Zip Drugs - I am glad to know you are a "potential buyer" - hopefully we can assist you in becoming a business owner.

The concept laid out in the article you referenced is to draw upon the existing traffic of the station, not to simply go into the restaurant or liquor store business.

The existing gas station clientele is the station's distribution channel. By adding additional products or services to push through the channel is the simplest way to increase the business. In other words, find more products to sell to the existing customer base and potentially draw new ones as well. It is fairly simple marketing as I am sure you recognize.

The idea is that if you were looking to acquire a gas station for example, one of the most obvious ways to grow the business is through the addition of ancillary services. Recognizing an opportunity where a station is doing well, but not great, but has the demographics to support ancillary services, is often a tremendous opportunity.

One thing is certain; operating a gas station provides infinitely more "ease of management" than a restaurant.

By the way, without sounding self-serving, get a copy of my guide How to Buy A Good Business At A Great Price at http://www.diomo.com . I know you have been looking for quite a while - it's going to be a tremendous resource for you.