Tiffany runs a high-street hairdresser. It’s her own business and is profitable; however, her lease is coming to an end, the landlord is likely to want to hike the rent and, even worse, a Turkish barber has opened up on the same road and is undercutting her (no pun intended as it is no laughing matter for her).
She is thinking of selling and wants to know what her options are. Will she generate enough to take it easy for a few years and be at home more for her children? Alternatively, she could use the money to set up another business or possibly the sale may yield very little and she might have to do cash in hand hairdressing seeing customers at home. To plan her life she needs to know how much she might realise from a sale. So, how would a valuer approach putting a price on Cut and Run?
Methodologies
Valuers tend to choose earnings-based methods for valuing businesses as they take more account of potential future profits, which is what most buyers are mainly interested in.
There are two main ways of doing this: using a private company price/earnings ratio (PER) and basing the valuation on Ebitda (earnings before interest, tax, depreciation and amortisation).
Cut and Run
Tiffany has been trading for a while and her lease is running down. Of course she has regular customers but their loyalty will be to the extent that it is to her, and future buyers may not think they can count on retaining them. But Cut and Run is a mature business with two long-term staff that has been trading successfully for years and still has a value. All these things will influence the multipliers used in the valuations.
Asset Valuation
Often shopfront businesses have had a sizeable amount of money put into the machinery, fixtures, fittings and signage, which has a value to someone continuing the business.
Tiffany calculates that she has spent around £30,000 on the current salon interiors and equipment. This is what she paid for the assets brand new which, all were bought at different times and so have different levels of wear.
There is no official method of caluclating their second hand value and often the purchase of assets is negotiated seperately to the main valuation and added on. It can be done with a price on each individual item but often is done as rounded figure for the whole lot.
Tiffany wants to be cautious with her predictions of the valuations so assumes that a new buyer might want to change some items and is not going to want all the kit so she comes up witha conservative estimate of £15,000.
Price/earnings ratio
Typically valuers, will use the past three years’ figures, which in her case looks like this:
We can see from the table above that Cut and Run makes profit of £40,000 to £48,000 over the years. However that's not the full picture as Tiffany has been paying herself a salary, which would be accounted for before the profit figure. Therefore it is fair to say that the new owner would be able to realise this cash when they take over. Therefore it is normally considered fair in owner mnaged businesses to add this back. There are also some additional items here like depreciation and bank loan interest which can be added in certain scenarios.
The result is an average adjusted profit of £82,527 which is then multiplied by the P/E Ratio being used to create the final valuation.
In larger businesses more complex methods are used to build a ratio, often using multiple ratios combined to build a more targeted ratio for that specific business. The selection of ratios is often backed up by some logical reasoning but they are often subjective and tend to be the place where the valuation is argued over.
The main goal of that process is to find a big successful example of a competitor in that industry (usually FTSE level) and use their p/e ratio as a comparative ratio that is used to judge the trajectory of the small business. It is usually discounted by 50% at least and again combined with other ratios.
However, with small businesses like Tiffany's it is often the case that the owners/buyers do not understand the valuation comparison and so will just offer a single figure as a multiplier for profit. For small owner-managed businesses this is often between 1 and 2.5 on average.
Tiffany, like any seller is thinking about the money she needs to realise for her next steps in life and so has played around with the calculation. She has decided that if shes uses this approach she needs to receive 2.5 as multiplier to realise the cash level she wants.
A seller would probably question this multiple as subjective and attempt to drive it down, but that's only if they agree to this type of valuation.
At the very least the £206,317 can form the starting point for negotiations.
Ebitda ratio-based valuations
Often Ebitda valuations are used for larger businesses which are not owner managed. However the technique focuses on the profit per £1 of turnover deployed which is often easier to understand than comparative p/e ratios.
The valuer will take either the past year or the past three years of accounts as the starting point. The company’s Ebitda is used to create an agreed annual profits figure. Adjustments are made to the agreed profits figure to make it more representative of future years’ figures, and factors such as goodwill and other intangibles will be taken into account.
This figure is divided by the turnover to generate the Ebitda ratio, which is expressed as a percentage. The higher the number, the more profitable the company is.
The Ebitda ratio is a measure of profit per pound of turnover. The Ebitda ratio will affect what multiplier is used. A company with a 45% Ebitda ratio will be able to demand a higher multiplier, eg, x4 rather than x3.5, than one with a 30% Ebitda ratio because it is more profitable. Generally, a smaller company will try to have the same Ebitda multiplier as a larger company but there are often stark differences in some industries.
The example here shows how using Ebitda to create a valuation works in practice.
The Ebitda ratio equals profit of £72,000 divided by turnover of £220,000 multiplied by 100.
Tiffany's figures produce a fairly good ratio of 36.3%.
In theory the multiplier would correlate to this and be 3.63 against the profit which would achieve a valuation of £289,964.
However often people calculate the Ebitda % and then the buyer will offer a multiple that can be different to this, especially at this size of business.
For Tiffany this looks like a much higher valuation that she would prefer to use. However in practice a buyer will rightly see this is a subjective choice but it is still a positive for Tiffany as she can still use it as tool to help push up whatever valuation negotiation that will inevitably ensue.
Want help valuing your business?
Professional help is likely to be needed to value a business accurately. The friendly team at Finsbury Robinson will be able to deal with all your questions and give you a figure that you can take forward into negotiations. For advice on valuing or selling a business please call us on 020 8858 4303 or email us at info@finsburyrobinson.co.uk
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