by Joey Young | March 29, 2021
Editor’s Note: This is the third article of a four-part series. Access the entire series at the bottom of this article.
In the previous two articles we determined that the health club we want to purchase has an annual net profit of $100,000. We then made adjustments to that amount through EBDITA calculation bringing the cash flow to $135,000. We then took that amount and ultimately raised it to $154,000 based on several items that affected the cash flow and called it the owner’s cash flow (OCF). So, how do you determine the value of a business based on the OCF?
First, recognize that you will be paying a multiple of that number. Usually, the range for buying a business would be between 1x and 10x the OCF but it is rare for a small-to-medium-sized business to sell for much more than 5x the OCF. The reason we apply multiples to our OCF is to show what sort of annual return on investment (ROI) we would get from each potential price.
Example: The range of multiples, prices, and returns on investment for the gym would likely be:
PRICE OF THE BUSINESS ROI
1x cash flow= $154,000 100%
2x cash flow= $308,000 50%
3x cash flow= $462,000 33%
4x cash flow= $616,000 25%
5x cash flow= $770,000 20%
Think about it like this. If you paid $462,000 for a business that makes $154,000 per year in cash flow, you would be making 33% annual return on your investment (33% of $462,000 is $154,000). But is that a good ROI? Or should you pay a different multiple? We already know what the OCF was for last year, but the way to determine the most appropriate multiple for a purchase is to make a good prediction about what the OCF of the business will be in the future, because when you’re talking about investing your money, only the future cash flows matter. The first thing you could do is look at an industry comp.
What is a “comp”? Why does it matter?
Comp is a nickname for comparison. It means that you might compare how much a typical business like a gym might sell for in terms of what multiple of cash flow is typically applied. Sometimes comps make sense, other times they don’t. For me, I don’t care how other similar businesses are performing, I’m only interested in the business I’m considering buying. Therefore, I don’t put a lot of faith in comps as a definitive choice for a multiple, but a buyer might get an idea of where to start thinking about an appropriate multiple by looking at comps (believe me, the seller will look at comps too) and then adjust it from there based on realistic future expectations.
Brokers will often show you a comp report, but Florida SBDC Network consultants often also have access to free comp reports thru BizBuySell.com. For health clubs, the Florida comparison report’s median multiple for an OCF calculation is 2.3x the owner’s cash flow. These comp multiples for an OCF already include the variable of an owner’s salary within them, so that is why we didn’t adjust for owner’s salary earlier in our cash flow.
We might start by taking that 2.3 multiple and adjusting it for the following items that indicate potential future performance of the business:
- Goodwill: Technically, goodwill is any amount you might pay over what the company is actually worth on paper. That means it’s actually an accounting concept. The problem is that sellers often consider every sacrifice they ever made to be a valuable item that should be paid for above and beyond the calculated OCF and multiple. But as a new owner you are going to be sacrificing just as much as the previous owner and that’s just the nature of owning a business. Business models pivot very quickly in a modern economy and every owner will face the challenge of adjusting to changing markets. In short, the only additional goodwill value that you should consider increasing your multiple over is goodwill that truly provides you with additional profits to the OCF, or perhaps more stable profits than you might ordinarily receive, producing a less risky investment.
Example: If the City of Clearwater has recently signed a 10-year contract with the gym to pay for all city employees’ memberships, that would qualify as a very valuable reason to pay a higher price for the business. That contract predicts something about the profitability and stability of the future. So, we might be amenable to an offer of a multiple of OCF that is closer to 3x than 2.3x.
- Current trend of net profitability: Was the profitability of the business steadily increasing or decreasing over the last three to five years? If the business is dying, the multiple paid for it should be lower, 1x or 2x maximum, or maybe not purchased at all. You can see the direction of the business by quickly glancing at the historical revenues over the last three to five years but be sure to look at the profitability of those years as well because expenses can increase dramatically in things like commercial property rental rates, or perhaps higher minimum wages required by recent law. Let’s assume that the revenues decreased by three percent each year for the last three years, and the profit decreased similarly as well.
Example: That might lower the multiple from 3x to 2.6x cash flow for the gym.
- Valid expectations: Is there any real reason to believe that the current business model will make more or less profit in the coming years regardless of its history? For example, are the other health clubs in the area closing? Is the city the gym is located in building a large, low-cost community gym? Is the landlord about to double the rent cost? Will a pending $15 minimum wage increase nearly double your payroll expenses? This will take hard research on the buyer’s part, but research will likely be the easiest job you ever do while owning a business, so don’t skip it.
- Barriers to entry and competitive advantages: Does the business have an advantage that limits competition from moving in? Maybe some city laws limiting the number of tow truck companies? Or the exclusive property location is attractive to a large number of residents who live nearby (that’s important in the gym business).
Example: A new hotel adjacent to the gym is being built. We might consider raising the multiple in anticipation of arranging hotel guest “day passes” for sale. Perhaps the multiple rises back to 3x OCF as a result.
- Online reviews: Make sure to read the online reviews of the company for insight into what the community thinks of the business. Bad reviews can often deserve lower multiples of OCF because it takes time to build a reputation back.
If you reasonably think that business will become more profitable over the years you can then justify paying a higher-than-average multiple of cash flow for it. In this case it might be reasonable to pay $462,000, 3x the $154,000 OCF.