Business Buyers Look For Real Profits

Let's look at the market. Way back in 1987 (and some even now) there were stocks that were selling for 22 times earnings. In layman's language, if you bought one of those stocks and its earnings remained constant, it would take you twenty two years to recover your investment. It's no wonder the market is in need of a correction from time to time. That's another way of saying that the market was grossly overvalued. And again in layman's language the stock market is saying, "Hey, on takeovers today, we want more stock swaps, more cash and less debt." How about that!

A well known market "Guru" said it best, "One era is ending, another beginning." Highly leveraged buyouts are in trouble because in a soft or down market assets are hard to sell off and there isn't enough cash flow (profits) available to make the loan re-payments that are due.

Small Business Owners - Listen Up:

So what does this mean to the small business owner? It goes something like this , , , build your business base on profit! And that means real cash profit, the kind that shows up on financial statements and the kind you pay taxes on. Why?

Let's take a hypothetical company called ABC Distribution. They do about $1-1/2 million in sales and like many firms have experienced good growth in their 15 plus year history. The reinvested available cash into inventory and equipment and each year have shown a negligible profit on their tax return. The owner is 59 years old, married and has two children who are not interested in the business. One morning, the owner has a mild stroke. Shortly thereafter he comes to the realization that while his wife has been somewhat active in the business, she could not manage it "alone." He decides to put his business on the market. He feels it's a really good business, well established, with good people and he should get a good price when it sells. Right? Probably not.

Why not? Let's assume we have a qualified buyer who is motivated to purchase. But at what price? The owner wants "X" because he "knows" his business is worth it. The buyer, however, will only gamble on a price that for the most part represents the value of the inventory and equipment. The buyer is saying to the owner "If I accept your asking price it will take me too long to recover my investment, considering the risk." Why? Because the price/earnings ratio on this business is too high.

Today's Buyers Are "Savvy":

When a buyer buys a business, the purchase price, for the most part, is based upon the demonstrated record of profit (earnings) through today. Not next month, next year, or over the next several years. The past record through today.

In each of the mathematical formulas used in our business valuation model, the presence of profit has a dynamic if not startling effect on the business value. Great care is taken to meticulously identify and re-cast the total profits in each business we value. Let's take an example of a small business with an indicated annual profit of $11,000. Using a standard capitalization rate (Cap Rate), that works out to a business value of $42,307, when just considering the income stream. But should that same business boost its total annual profit to $61,000, and we use the same cap rate, the value of the income stream is now a whopping $305,000. This increase in value for just adding $50,000 per year to the total profit!

P/E Ratios . . . Tell The Story!

Now let's go back to our hypothetical company. If ABC Distributing had supporting materials (valuation documents, updated P&Ls, balance sheets and cash flow statements) to verify that the business had a record of consistent and increasing profitability in recent years, ending with a healthy profit last year and continuing through the present, what kind of response could we anticipate from our buyer, when exposed to the seller's asking price of "X." In addition, if that price falls into a P/E Ratio range of from 4 to 7 (years in which to recover the total purchase investment), the deal can be done with only moderate risk. Not the substantial risk when there was little demonstrated profit history and a much higher P/E Ratio.

So what is our market lesson for the small business owner? If it looks like your business may be sold , divested or re-organized in the next 5 to 10 years, keep you P/E Ratios low by packing your business with "visible" profits, for any and all to see. Your sale, when it happens, will then be easier, quicker and you'll get a higher price!