By William Bruce
As a business broker and appraiser, I’m often asked about how to value a retail business. The valuation of retail businesses is not an exact science but there are guidelines and rules-of-thumb that can be used for a close approximation of value of a retail business.
Certain situations require a formal business appraisal including the larger merger-acquisition transactions, SBA loan applications, management performance tracking, estate planning, divorce — or the most dreaded of all — IRS issues. After all, a professional, fully documented appraisal certainly takes the guesswork out of the situation.
However, what we’re talking about here is not a formal appraisal but rather the informal methods of quickly approximating the value of a retail business. The guidelines we’ll quote are averages derived from hundreds of completed transactions reported to regional and national databases.
There are two methods of quickly approximating the value of a business: (1) applying a multiple to the discretionary earnings of the business and (2) applying a percentage to the annual gross revenue of the business.
The most accurate of the two methods seeks to approximate the value of a business by applying a multiple to the company’s discretionary earnings.
What are discretionary earnings? It is NOT the profit or loss that you show Uncle Sam on your tax return. To put it delicately, almost all business owners run some expenses through the business that are not — a’hem – absolutely necessary to the operation of the business.
Discretionary earnings are the total cash that the business generates in a year that is available to the owner after deductions for only the necessary operating expenses. Another way to define discretionary earnings is that it is the “total owner’s benefit” derived from owning the business, regardless of how the owner takes the money out of the business. It is the amount of cash left over after only the necessary expenses that is available for (1) owner’s remuneration, (2) return on investment and (3) debt service, if any.
If you’re not sure of how to calculate discretionary earnings, an accountant or professional business broker can compute it for you.
Practically all retail businesses will appraise for somewhere between 1.5 to 3 times discretionary earnings plus inventory at cost. Exactly where in this range that a specific business will fall depends on the size and type of the retail shop plus its revenue trends.
The second method of estimating the value of a business is less accurate. This method applies a percentage to the operation’s annual gross revenue to approximate value. This method of appraisal assumes the business is earning the average bottom line profit for its peer group. That’s a big assumption!
But making that assumption, we know that almost all retail businesses will appraise for somewhere between 30 and 35 percent of gross annual revenue plus inventory at cost.
As indicated above, inventory for resale should be added at cost to the formula result. If the business owns real estate, the value of the realty should also be added to the guideline result.
However, you as the owner, seller or buyer of the business are the final arbiter of what the business is worth to you. Remember, these guidelines are only averages. And the guidelines certainly don’t take into account any special considerations or any future plans that an owner might have for the business. What a particular business might be worth to you may be more or less than it’s worth to the next person who looks at it.
Here are additional articles that might be of interest: How to Analyze a Business You’re Considering Buying, How to Make a Written Offer to Buy a Business and How to Handle the Due Diligence Investigation When Buying a Business.
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