Business Valuation

Profit and Sustainability

One of the most important factors in determining value is profitability, as long as profitability is matched by dependable cash flow. An increase in profit will generally lead to an increase in value.

Some of the steps that can be taken to increase profit include:

improving gross margins

improving debt collections

reducing stock levels

reducing staff by improved processes

better deployment of staff (such as salesmen out selling rather than sitting in the office)

reducing overheads

increasing product range.

However, this doesn’t mean that all businesses with the same level of profitability will be valued at the same amount. For example, there may be a successful restaurant in a small row of shops in an inner suburb. The newsagent next door is equally profitable. However, the restaurant’s profitability is closely related to the owner’s personal skill as a chef and the time he or she spends working, while the newsagent is profitable because there is a train station nearby and commuters buy newspapers on the way to work.

In the marketplace, the restaurant is probably worth less than the newsagent, despite the same level of profitability. The reason for this is, with the departure of the restaurant’s present owner it’s more likely that the profitability of the restaurant will suffer. The business owner needs to be able to show the quality and skills of the rest of the staff, the contribution they make to profit, and the lack of reliance on his or her own personal efforts.

Thus, while profitability is important, it is the expectation of continued profitability from the business structure itself, rather than from the ability of the present owner, that is most important.

This can come as a surprise to many small business owners who have worked hard to build up the long-term profitability of their business but, in doing so, have become personally closely associated with the success and profitability of their business.

It is a particular problem with professional services businesses where the reputation of the owner is closely associated with the business’ success. So the owner needs to reduce his influence on the profitability of the business in order to maximise its value. For example, by establishing a management team, improving formality of management, introducing customers to others in the business and keeping records of customer contacts, and excluding the owner’s name from the business.

A business that has good systems, is well located, enjoys a long-standing reputation and has few immediate competitors should be able to maintain its profits, and such a business would usually be said to have a low risk of earning those profits.

Because of this low risk, the value of the business will be higher than that of a business where there is a high risk that the profit may not be sustained. The future profits of a business that has just started will be high risk, as will a business that has a low barrier to competitors entering the marketplace or a business subject to seasonal or weather fluctuations.