Businesses showing exceptional growth in business earnings and/or profits over the past 3 years may be subject to the buyer and their advisors ‘averaging’ these over the three years instead of relying on the most recent financial year.
Buyers and their advisors also have a tendency to apply the same multiple or ‘Cap Rate’ on the Average Earnings as would normally apply to the most recent financial year results.
Below is the actual correspondence in regards to a buyer’s comments and concerns regarding the potential purchase of a business listed at $800,000 + plus stock and working capital of around $230,000 for a total investment of $1,030,000.
The listing price of this completed business sale was based on the 2010 FY adjusted Business Earnings / Net Profit of $368,607.
Buyer and their advisor’s comment:
“I never like looking at last year’s profit alone to determine the value, however I do agree with you that the earnings trend is critical in determining the value.”
“Looking at the weighted averages over the most recent three years tells a much more realistic story. Looking at weighted averages based on 50%, 30%, and 20% for 2010, 2009, 2008 respectively, and at a multiple of say three times would give a total investment value of around $800,000.”
“This would equate to $800,000 of total funds invested less Stock and Working Capital for a business sale price of approximately $570,000 + $230,000 in stock and WC. “
Our short answer was:
Averaging the earnings does NOT affect the value of a business.
The business showed exceptional growth over the past 3 years as:
Response from the Broker to the Buyer and their advisors:
A lot of people see growth as a risk! We hear this when people say “it only earned that level of net for one year”.
Is a business with no growth over 3 years more reliable in retaining Future Maintainable Earnings (FME) than a business showing continued growth especially during the GFC?
We would always argue that sustainable growth is less risky than showing no growth at all. The question for you as the potential buyer:
“Do you see the growth in this business as being sustainable?”
When we advise clients on appropriate multiples, it is based on (among other things) actual historical completed sales history of other business sales which most buyers and their accountants would not have access to.
When using Average Earnings over a period of 3 years, the multiple is affected by the Earnings Trend.
Average Earnings reduces the validity of comparison between two opportunities. The diagram below shows the earnings from 3 separate businesses with 3 year average earnings of $200k in each case. These businesses should have dramatically different values due to their upward or downward trends.
We would typically compare business opportunities based on the most recently completed year’s earnings and then factor the growth or decline into the multiple to be used to determine the price.
Any assessment that uses 3 year average earnings and does not adjust the multiple or cap rate to reflect the growth or decline in profits would be considered inadequate.
- Uptrend means the weighted average multiple is always higher than the multiple used based only on last year’s business earnings
- Stable earnings means the weighted average multiple is similar or the same as the multiple used based on last year’s business earnings
- Downtrend means the weighted average multiple is always lower than the multiple used based only on last year’s business earnings
If the business is in an uptrend and the buyer (or advisor) wants to use a different earnings calculation as shown above, then to use this logic they must also change the multiple to be used as well.
Many buyers and their advisors do not have access to completed business sales data therefore they may use information from text books or apply known ‘rules of thumb’ which do not take into account the sales and profit trend of the business.
‘Averaging the Earnings’ does NOT affect the actual sale value of a business!
The business sold for the full listing price of $800,000 plus stock and working capital.