Step 1 – Adjusting The Accounting Profit
The process of establishing a value or market price for businesses is structured and evidence based.
In the first instance the profit of the business, be it dry cleaning or any other small business, has to be determined according to market accepted methods. Profit a business shows in Financial Statements may not necessarily be the profit used to determine a price for the business. That profit shown is adjusted to an amount after normal running costs of the business but before any consideration for depreciation, interest payments, non-business related costs that have been expensed, tax and a wage or salary to one owner involved in the day-to-day running of the business regardless of structure (i.e., sole partner, partnership or private company).
Step 2 – Determining The Capitalisation Rate
So, now the profit has been adjusted we apply a formula to that profit to provide us with a market price. The formula is referred to as the Return on Investment (ROI) method and is effectively, a capitalisation of the profit at a percentage rate to result in a market price, similar to capitalising commercial rent to help determine commercial property value.
The formula in execution is demonstrated as:
MARKET PRICE = PROFIT X 100/CAPITALISATION RATE.
The capitalisation rate is ideally, determined by the rates realised by the sale of similar businesses (i.e., dry cleaners). That rate, usually a range, is then applied to the profit of the business.
Fortunately, with dry cleaning businesses we have an abundance of historic sales to draw on to establish a capitalisation rate to apply to profit. Dry cleaning businesses have historically, realised capitalisation rates ranging from 30% to 75%, depending on profit, with a median 45% to 50% (with a median profit of $150,000 per annum). The broad range in the capitalisation rate is due predominantly to profit level and age and condition of plant and equipment among other things.
Profit has historically ranged from $100,000 to $300,000 per annum.
The market prices achieved in the sale of dry cleaning businesses have provided evidence which can be used to determine the market price for dry cleaners at different profit levels.
For instance, dry cleaning businesses realising profits of around $100,000 per annum have sold for prices reflecting a capitalisation rate of profit of between 50% and 70% resulting in market price of between:
100,000 X 100/70 and 100,000 X 100/50.
That is, between $142,857, say, $145,000 and $200,000. (Note, the higher the capitalisation rate the lower the price).
Businesses with profits between $100,000 and $200,000 have achieved prices commensurate with capitalisation rates of 40% to 50%.
The table below provides profit levels and capitalisation rates realised in the sale of dry cleaning businesses.
PROFIT: CAPITALISATION RATE:
Up to $100,000 50% to 70%
$100,000 to $200,000 40% to 50 %
$200,000 to $300,000 35% to 40%.
Step 3 – Calculating The Market Price
We can now use the profit a particular business realises after the appropriate adjustments, to provide an indication of where the market price may lay (bear in mind, the exercise is a guide only and there are other factors that ultimately come into play in final pricing).
If, for instance, a dry cleaning enterprise is generating an annual profit of around $235,000 then it could realise a price reflecting a capitalisation rate of 35% to 40%. Applying the above to the profit provides an indicative price range of:
$235,000 X 100/40 and $235,000 X 100/35.
That is, between $587,500 and $671,428.
The price is inclusive of goodwill, plant and equipment and stock (although not major in the industry).
While the above exercise can provide a handy preliminary guide to the value of your business, as mentioned at the outset there are many factors relating to business overheads, location, plant and equipment and tenure that will affect the ultimate market price.
If you have any queries or would like more information, please contact Con Mast on 9481 4422.