By Troy L. Harmon, CFA, CVA | Chief Investment Officer
In talking to business owners about the value of their business, I often run into those who focus on the Price-to-Revenue (P/R) ratio as the best way to determine that value. However, I find the use of a single ratio allows one to overlook several key points in the value of a business.
Assuming the business owner has done her homework, she would have sought data on sales of businesses of similar size in her industry and even those in a similar geographic area. All of these are important inputs in the calculation of a business valuation. Once she has narrowed the list of historic transactions by these factors she may get a rough idea of what has gone on in the history of her industry, but it still leaves out many of the details important to the value of a specific on-going enterprise.
Let’s face it, using these figures assumes your business fits the mold of the average you can derive using the factors listed above. What it misses are the measures of growth (historic and potential), profitability and product and service differentiation.
Growth commands a premium in the marketplace. Think of your business today relative to how it all began. Maybe the business started last year, maybe 20 years ago. The difference in these two is likely their growth potential. The business, having started last year, is not likely to have a widely recognized brand like the 20 year old business, but if revenues have grown substantially over the short period there is likely value in its potential. Even the established business should consider its growth potential relative to the average business represented in the ratio used for its value.
Unfortunately, this concept is not generally reported on business transactions. However, looking at revenue growth in a specific business relative to publicly available industry peers can give you a basis for asking a premium price.
Profitability is another area where little is reported in historic transaction databases. The aforementioned P/R doesn’t consider anything beyond the amount of revenue reported by the seller of the business. Who knows what it took to get to that revenue. Were discounts applied to entice sales? That would reduce profitability. The questions pile up. Was the owner fully involved? Was the owner an awesome salesperson? Was the owner a savvy business person? None of these questions are answered by a transaction database, but each of them impact the value applied to their business, and if you use their ratios, the lack of answers applies to your business too.
The final thought here, if you provide premium service and a premium product, you are likely to command a premium price for those services in the market. Premium products and service may come with higher expenses, but these expenses are often more than offset by the premium price charged. This is an intangible asset to your company. The value of intangible assets are not always easily identified, but relative profitability is how they are quantified.
If your business is more profitable than industry peers, it should follow that you are doing something better than other businesses and people are willing to pay more for it. It should also follow logically that your business is more valuable than the average ratio would indicate.
Some calculations of business value may be best served by the use of a ratio alone. However, if you are trying to prove your net worth to a banker for a loan, convince a partner to invest in your operations or trying to sell the whole operation to fund your retirement, it probably warrants deeper consideration.
If you have questions, contact the Experts at Henssler Financial: