The Basics of Business Valuation

Craig Salvay

It was after 2 p.m. when we got up from the table. My client, Sarah, was exhausted, not from overeating … but from thinking. The meal had been more than the food … more than the wine. It had been a time of close observation of the $5 million Orange County, California restaurant, itself. You see, she was contemplating the purchase of the restaurant and had asked me to come observe it over lunch. She was enchanted by the fact that the place was full of businesswomen at lunch (a sign that the food is good and nutritional); however, she had little idea how that or any other fact figured into the value of the operation.

I explained that the basics of business valuation are simple on the surface. "And that is exactly where you should stay with the subject, at least initially," I suggested. Sarah pulled a paperback book from her briefcase. It was a "how to" title directed to those interested in buying a business. "Let’s see," she muttered as she thumbed the pages for a specific reference. "Ah, here it is! The ‘rule of thumb’ for the purchase of a single unit restaurant is 2.5 to 4.5 times cash flow. But what does that mean?" I suggested that she temporarily retire the book in favor of our consideration of the most fundamental question in valuing a business … how much of the purchase can be financed?

"To answer this question, you only need to submit a loan application to an interested lender or two," I said. "Then, the lender will take a look at the attributes of the business and get back to you with proposed loan terms." Sarah was not convinced that it was that simple. However, she listened as I listed the internal and external factors that lenders most often consider in extending credit.

Among the most important internal factors considered by lenders are:

The trend, stability and predictability of revenues. Lenders attempt to assess the extent to which internal factors (e.g., aging capital assets, stagnant management) and external factors (e.g., competition, location, access) make the prediction and stability of revenues ascertainable.

The trends in labor productivity (simply measured as the number of dollars of revenue per hour of labor) and in the wage/rate and salaries (typically dictated by market filled with other businesses competing for the same labor).

The trends in cost of consumable goods sold (in the case of a business that manufactures or sells tangible items). These are known as intermediate goods and are generally offered to a business by many competitive suppliers.

The cost of occupancy for the business. When passing a prison one day, a famous philosopher looked at the prisoners taking their morning walks in an open-air courtyard of the institution and noted, "There is only one law those prisoners cannot break: the law of gravity!" The same is true for any business.

The management of receivables (usually measured by trending ‘days in accounts receivable’) and the management of inventory (usually measured by trending ‘days in inventory’).

The age and condition of fixed assets (typically an assessment of the furniture, fixtures and equipment and the likelihood that they can continue to sustain present levels of revenue and net income).

Sarah suggested that those all sounded like financial characteristics of the company. "What about the actual operations?" she asked. I told her that the financial statements reflect the operations and that lenders are not qualified to know how to prepare, present and serve the food; however, the financial results of operations could be evaluated by them. "Alright," she accepted, "Then what about things like competition?" I continued.

Among the most important external factors considered by lenders are:

Access, visibility, parking, signage, zoning and other locational parameters that tend to give an advantage to the subject business.

Demographics (residential, commercial and industrial) that tend to advantage or disadvantage the business and its operation.

Competition and its strategic advantages such as: proximity to transportation and sources of labor, age and condition of plant and equipment, and vertical integration of factors of production.

Sarah looked out the window. She seemed to be studying the other businesses on the street, the traffic, the pedestrians, and the entrance to the beautiful residential neighborhood just up the street. It was quiet at the table for a minute or so. I finished my tea. Then the silence was broken by her question, "So the lender has all this information. Now, how does he or she determine how much to lend?" "That’s not too difficult a question, in concept," I suggested. I explained that the basic parameters considered by interested lenders base the amount they are willing to loan is determined by, among other factors:

The Free Cash Flow of the business (generally understood to be cash flow from operations MINUS a reasonable estimate for on-going capital expenditures needed to sustain that cash flow from operations).

Market rates of interest for similar loans from competitive lenders.

A repayment term that the lender believes the business will reasonably be able to meet.

"But the bank is not going to loan me the entire purchase price, is it? I mean, I am going to have to have some investment in the restaurant, aren’t I? I answered that equity is the amount of the "value" of the business that cannot be borrowed to acquire or re-capitalize it. Equity is typically the amount of cash that a purchaser is willing to invest at the time of his purchase, or that existing owner is willing to leave at risk in the business in a re-capitalization. Since lenders will only loan an amount of debt to a business that consumes some fraction (usually between 50 percent and 70 percent) of the amount of free cash flow, there is additional free cash flow left over as a return on invested equity. Equity is at greater risk than debt in any sale or liquidation of a business, therefore, equity-holders will always want a return on their investment that is greater than that required by debt-providers. "The precise amount of the return required by equity-holders is based on their perceived risk," I said. "Sometimes, rates of return on equity exceed the interest rate charged by debt-holders by more than 200 percent!" She was flabbergasted. She asked to know more particularly how a buyer like her is supposed to know what the true "value" of a business is.

"Value, like beauty, is in the eye of the beholder," I told her. I went onto suggest that when assessing the value of the restaurant, she should keep her eyes (and her mind) wide open and keep at least the following firmly in mind:

Try to understand the way that the target business is operated and its competitive advantages vis-à-vis other restaurants. "I see," she though out loud. "This place is full of women. We need to keep those customers coming back." "Precisely!" I said.

Understand the connections between the restaurant and its suppliers, and those between the restaurant and its customers.

Every business is part of an industry comprised of similar and related enterprises; in the case of a restaurant, it is called the ‘foodservice industry’. I urged Sarah to research the industry and its place in the overall economy, and to study the experts’ opinions about its future and the challenges it faces in the near-term and in the long-term.

We got up from lunch and headed for the door. Sarah turned to thank me, and added: "I don’t think that I’ll be going to the gym after work. I feel as though I’ve just had my workout for the day!"

Craig Salvay is President of S R Financial Group, Inc., an investment-banking firm based in Kansas City.