Revenue-Based Valuation of Businesses
Some business owners believe that their business valuation should be based on a multiple of their gross sales, or total sales unadjusted for the costs related to generating those sales. Although this valuation approach may work with some businesses in selected industries, it is not generally an appropriate valuation metric. The business model, competitive advantages, physical assets, and cost structure of a business are ignored when one solely bases a business valuation on gross sales. While a company’s gross sales are highly relevant, it is generally preferred to value a business based on its adjusted owner benefit (or true economic profit derived by the owner) while taking into account the company’s physical assets.
Margins and Cost Structure Important to Business Valuations
The main disadvantage of a business valuation based on gross sales is that businesses with similar revenues are not necessarily valued similarly. The gross sales of a business does not factor in the costs necessary to obtain the sales, which then results in the profits left over for the owner. A business that obtains its gross sales with a minimal level of costs will lead to a higher adjusted owner benefit and hence a higher valuation. Ultimately, a buyer of a business will want to know what their profits will be from the business. The gross sales does not fully answer this question, whereas the adjusted owner benefit (also known as Seller’s Discretionary Earnings or SDE) will tell a buyer what profits they can expect to receive from the business.
Revenue-Based Valuation May Distort Valuations
- A business valuation that solely relies on gross sales may lead to grossly underestimating or overestimating the true valuation of the business.
- For example, let us suppose two home healthcare agencies each have $1M in gross sales.
- Using a revenue-based valuation approach, they will each receive the same valuation since they have the same level of gross sales.
- In reality, however, they should have much different valuations because of stark differences in their cost structures, competitive advantages, and business models.
- A business valuation based on adjusted owner benefit will factor in these differences, because the adjusted owner benefit (or net profit) will reflect these differences.
- One of the home healthcare agencies may have been established for thirty years with a wide network of referral sources who refer patients to the business based on their outstanding reputation and level of customer service.
- This agency has no need to pay for costly advertising, while having lower employee recruitment and training costs due to its stability.
- In contrast, the other home healthcare agency has recently been established, and relies on costly marketers who take a large percentage of the gross sales.
- This other agency also has higher employee turnover and higher employee recruitment and retention costs due to its lack of stability and market presence.
- The higher operational costs of the other agency leads to a much lower level of adjusted owner benefit than the first agency.
- The differences in the adjusted owner benefit (which is the result of the first agency’s superior business model and competitive advantages) should be reflected in their respective business valuations.
Some Industries Use Revenue-Based Valuation Approach
A business valuation approach based on a multiple of revenue may be appropriate for businesses in certain industries with similar cost structures and standardized business models. Examples of such businesses include pool routes, small restaurants such as pizzerias, and insurance agencies. For such businesses, industry participants know the costs necessary to operate the business because they all have the same general business models without much differentiation. The revenue-based valuation approach often is used as a short-hand metric of business valuation by industry participants for such businesses.
Pool Routes Valued Based on Monthly Service Revenue
Pool routes are a unique service business which are valued as a multiple of its current monthly service billing amount. A pool route’s monthly service (customers are billed monthly) amount is the recurring revenue that the route generates from regular service. Pool routes all have similar costs related to truck expense, fuel expense, and chemical expense. Thus, once the currently monthly service amount is known, it is fairly simple for industry participants in the pool route industry to know what profits they can expect to generate from the route. Most pool routes sell for 9-12 x its monthly service billing amount. The valuation multiple depends on the tightness of the route, quality of customers on the route, and the ability to ensure a smooth transition of the route to the buyer.
Pizzeria Valuations Based On Weekly Sales
Many small restaurants – especially pizzerias – have similar cost structures and business models. Pizzerias typically pay about 30% of its sales in Cost of Goods Sold (COGS) related to food and beverage purchases. Occupancy costs for most pizzerias are similar in that they are relatively small spaces with rent below ten percent of total sales. Most industry participants in the casual dining industry also know the staffing expenses necessary to properly operate a small restaurant such as a pizzeria. Because of the similarity and standardization in the business models of most small restaurants such as pizzerias, the weekly gross sales allow many within the industry to gauge what their own profits would be from owning and operating the restaurant. This in turn allows such buyers to approximate its business valuation.
Insurance Agencies Valued by Book of Business
Insurance agencies are valued based on their annual earned commissions (after expenses paid to the insurance carrier) generated from the policy premiums of the agency’s current customers. Typically, insurance agencies are valued at about 2-7 x their book of business. The cost structure of how those commissions are earned (such as marketing expenses to procure customers and office overhead expenses as a percentage of sales) will greatly affect the multiple. The value of the insurance agency mainly lies in its customer base and ultimately in its book of business. Industry participants use this metric as the best and most efficient way to value insurance agencies.
While the revenue-based business valuation approach does have a role to play within some industries, it should not generally be used as a way to value businesses. Most business owners should understand that what ultimately drives their business valuation is the adjusted owner benefit that a buyer would expect to receive from buying the business.
Give Martin at Five Star Business Brokers of Palm Beach County a call today for a FREE evaluation of your business.