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August 20, 2017    

SellingStores

VALUING A RETAIL BUSINESS

By Mel Jones – President & CEO SellingStores

 

Unfortunately, as a broker, determining a business’ value is more of an art than a science particularly when a business doesn’t have good tax returns.  A retail business analysis of tax returns is exactly the same as for a restaurant analysis except there are different multiple applied. In the brokerage business, 80% of listings won’t have good tax returns due to either hiding of money or simply poor business management.  This doesn’t mean the business is worthless, it means we must look closer for value.  This article focuses on valuing retail businesses with no tax returns.

 

If there is one point learned about valuing restaurants, it is value is in the eyes of the beholder.  Where one buyer places a value of $150,000; another places a value of $75,000 on the exact same restaurant.  What drives these value differences isn’t a mystery, nor is it unique to the restaurant business.

 

SELLER’S VALUE

A seller has a unique set of value variables influencing price such as the seller’s investment in the business; seller’s financial strength; businesses’ financial strength; seller’s emotional attachment to the business; quality of the lease and; seller’s physical and mental situation to just name a few.  The broker’s job is to access each variable having the most influence on the Seller before honing in on a price. If a seller is in financial trouble, then the price needs to be lower than if the seller’s business was thriving.  If the seller is physically and mentally worn-out, the price needs to be lower than if the seller was enthusiastic about the business. The degree of adjustment depends on the degree of each variable.

 

BUYER’S VALUE

On the flip side of the value equation, a buyer looks at variables such as cost avoidance; desire to be in the business; time to market; buyer’s education on understanding business value; buyer’s emotional attachment to the business; buyer’s financial strength; buyer’s need to buy a job; buyer’s income expectations; buyer’s business experience; businesses financial strength, and; buyer’s business concept.  A broker needs to understand these variables and how they play into selling the product before going to market.

 

For example, in a strong economy, money tends to be plentiful – SBA rates tend to be lower and home equities are fat – people feel rich!  In recent years we experienced this with the housing boom.  People had enormous wealth in the equity value of their home.  So it’s likely when buyers have financial strength, the prices of businesses will be higher than when the economy isn’t doing as well.  In another example, if business space is limited by simple supply and demand laws or even local government regulations, then the sales price will tend to be higher than in a situation where there is a glut of businesses on the market.

 

Although a broker won’t know exactly which variables drives buyers to purchase a business, good brokers understand what generally drives buyers at any particular moment in the local business sales environment.  

 

RETAIL STORE VALUE

Basically, there are two differences between valuing a restaurant and valuing a retail business – cost to build and inventory.  Keep in mind this article is only for businesses not having good tax returns. Inventory is ALWAYS an addition to the sales price and a commission is earned on the inventory portion of the sale. 

 

Determining whether a retail business is profitable or not while on a listing appointment is critical to understanding whether the business is worth listing. A good broker will screen the listing by phone prior to setting up a listing appointment. 

 

Two benchmarks of profitability are used in retail to determine whether the business is successful – sales per employee and sales per square foot.  The charts below provide guidelines to those benchmarks. 

 

Of course, benchmarks must be blended with other information received during the telephone interview in order to make a sound conclusion of whether or not to set a listing appointment.  Remember, the broker’s job during the telephone interview is to gather information to determine whether there is a good listing to be had or whether to thank the business owner and simply say we can’t sell it!  Your time is precious. Don’t waste it on bad listing leads.  The good agent makes fast informative decisions on listing quality using these guidelines.

 

If during the interview, it is discovered the business has numbers significantly below benchmark in Chart #1, #2, and #3 (except Payroll % of Sales, which a number significantly above would indicate poor performance) indicates a business likely losing money.  What is significant?  Every situation is different, but more than 10% to 15% off the number indicates a possible profitability/performance issue – but not conclusive. It isn’t black and white.  There are a number of variables affecting the benchmark such as rent and gross margins.   Points above the benchmark indicate a business is likely profitable.   Use these benchmarks to make value decision while on the listing interview.

 

During an interview the agent needs to ask what are the annual gross sales? the stores sq. ft.? And the number of full time equivalent employees (FTE’S)?  FTE’s mean one person working 40 hours a week.  On the FTE’s most owners, for example, will say they something like 2 full time and 6 part time employees.  The broker needs to probe a bit lower to understand the part time number by asking roughly how many hours each part time person works.  Don’t assume part time means 20 hours a week.  It could be 10 or 30 hours a week.

 

CHART #1 – SALES PER SQUARE FOOT

Major Shopping Malls – keep in mind rents are very high in shopping malls.

 

Type of Business                                                         Sales per Sq. Ft.

Jewelry                                                                                   $880  

Shoes – Men’s                                                                      $514

Shoes – Children                                                                  $439

Accessories – Women’s                                                      $478

Specialty Food Stores                                                         $430

Personal Health & Care                                                       $411

Electronics                                                                             $355

Sporting Goods                                                                     $246

Stationary & Cards                                                               $229

Toys & Hobbies                                                                    $221

Automotive Parts                                                                  $210  

Books                                                                                     $199

 

Source: Newspaper Association of America, as shown on www.bizstats.com

 

Neighborhood Shopping Center

 

Type of Business                                                         Sales per Sq. Ft.

General Merchandise                                                           $100

Clothing & accessories                                                        $201

Shoes                                                                                     $145

Automotive                                                                             $136

Hobby Shop/Special Interests                                             $163

Gift/Specialty                                                                         $149

Jewelry                                                                                   $280

Liquor                                                                                     $217

Other Retail                                                                            $143

 

Source: Newspaper Association of America, as shown on www.bizstats.com

 

CHART #2 SALES PER EMPLOYEE & PAYROLL COST

Employee productivity is another important measure of profitability.

 

Type of Retailer                                             Payroll % of Sales     Sales per employee

Automotive parts & Accessories                               15.6%                            $129k

Tire Stores                                                                    18.1%                            $138k

Floor Covering Stores                                                 14.9%                            $171k

Camera & photographic                                             14.4%                            $129k

Nursery & Garden                                                        10.0%                            $198k

Children’s Clothing                                                      10.2%                            $100k

Family Shoe Store                                                       11.0%                            $113k

Athletic Footwear Store                                              10.5%                            $118k

Sporting Goods                                                            11.6%                            $114k

Hobby, toy & game store                                            9.5%                              $129k

Book Store                                                                   11.8%                            $104k

Florist                                                                            21.3%                            $52k

Gift, novelty & Souvenir store                                      14.2%                            $70k

Used Merchandise Store                                            19.9%                            $62k

Pet & pet Supplies Stores                                          12.9%                            $90k

 

Source: Newspaper Association of America, as shown on www.bizstats.com

 

ASSET SALE

The broker now determines after the phone interview the listing opportunity is worth chasing even though the business is seemingly losing money.  So when a business is losing money how is the value set?  Look at the chart title “Rule of Thumb for Retail Businesses” to help zero in on a value.  This chart provides general guidelines and averages for what a retail business sell for in the marketplace.  Finding accurate and reliable data is a difficult task where business sales information is not required to report unlike the residential real estate business.  The chart was extracted from Tom West’s “2006 Business Reference Guide.”  Every agent should purchase the book to help establish a sales price for a particular business.  The attached chart contains summary data by type of business and should be used as a guide, not as a bible!  Again, this is an art, not a science.

 

Two factors are looked at to determine price – (1) Original FF&E cost, and (2) gross sales excluding sales tax. 

 

FF&E

What the restaurant business valuation process taught us was when a business loses money we can expect the sales price to be 20% to 25% of the original cost for FF&E if it’s in good shape.  Or 10 to 15% if the FF&E is in poor shape. Of course, this is a “Rule of Thumb” meaning there could be cases where 50 cents on the dollar can be realized and other cases where not even 10 cents on the dollar attracts buyers.  A black and white mentality here will have the agent missing listings or taking listings that won’t sell.

 

The obvious question becomes what is the investment in FF&E for a particular retail business?  The attached chart shows the FF&E investment in a particular retail business.  Of course, the agent needs to use judgment as to whether the amount in the chart makes sense.  The agent should simply ask the seller how much it costs to build such a store and compare it to the chart.  If there is significant differences, either the chart is wrong, which it certainly could be, or the Seller is telling an untruth, and it certainly could be too.  Again, it is an art, not a science!

 

Use rule of thumb charts with caution and thought!  The ranges are great within each category because the quality of the store can greatly vary.  With time the agent begins to gain history and experience with the cost of such facilities.  But each deal is unique with a unique set of circumstances.

 

GROSS SALES PERCENTAGE

As in the restaurant business, a percent of sales can help a broker determine whether a listing is within reason.  But don’t completely rely on this method because it can give bad answers.

 

For example, the “Rule of Thumb for Retail Business” shows a coffee house should sell of 45% of gross sales. But take a coffee house doing $500,000 gross per year with rent of $3,000 a month.   This coffee house will net $170,000. or more  Using the percentage method dictates a price of $225,000.  Using a cash flow multiplier yields a price Greater than $350,000, significantly different results than the percentage method. Use the percentage method cautiously.  It isn’t the Torah. It is merely a gauge to determine reasonableness.  Of course, if no other information exists, then use it and use judgment.

 

BAD LEASES

The lease plays an important variable in the pricing decision. Don’t underestimate or overestimate the effects of a good or bad lease on price.  In the past few years landlords have pumped up rents because unsophisticated tenants signed over-priced leases relative to the expected sales volumes.  Bad leases translate into lower values and bad leases are tough sales at any price. 

 

Recently, one of our agents had a deal with a bad lease.  The rent all-in was about $3.45 sq. ft. meaning the tenant needs to do more than $100,000 a month to make a fair profit in a dead retail center – no major anchor.   We all know from our experience, it is rare to find a restaurant doing $100,000 a month let along a small pizza joint doing that volume.  A buyer attempted to renegotiate the lease prior to getting into contract.  Of course, his efforts failed…they never believe us do they!  So the Seller paid the Buyer $35,000 to take over the restaurant.  In other words, the lease was so bad, the price ended-up being negative, fundamentally reducing the monthly rent.

 

Price bad leases accordingly. 

 

INVENTORY VALUE

In most retail businesses, inventory is the largest number in terms of the total sales price.  In other words, it is not uncommon to see a retail business sell for $50,000+200,000 of inventory.  This is an important point.  When inventory is that large, the broker must make an extra effort to understand how to value it.  A few questions the broker must ask is: How is the inventory valued?  How old is the inventory? How often does the inventory turn-over? What systems are in place to account for inventory?  How often are physical inventory counts taken?

 

Valuing inventory has challenged the best accountants over the centuries and has often been driven by tax or income pressures for a simple reason - a change in inventory value has a corresponding and opposite effect on income.  In other words, an increase in inventory value reduces cost of sales, which increases income – for those not familiar with profit & loss and balance sheets relationships will have a hard time understanding the mechanics involved. 

 

Here is another way to understand this very important concept – A store owner buys exactly $100,000 of inventory.   According to his accounting system he sells $90,000 of the inventory. The cost of sales is then $90,000, reducing the book inventory to $10,000.  The owner takes physical inventory and finds the inventory value is $15,000.  Where the increase comes from doesn’t matter here, just the concept does.  The balance sheet shows $5,000 more inventory then the book, which means the owner expensed too much to the profit & loss statement.  Correspondingly, the cost of sales is over-state by $5,000.  So the owner must adjust the cost of sales or reduce costs down by $5,000 and increase inventory value by $5,000.  When all the dust settles, the cost of sales is $85,000 and inventory $15,000, taking us back to the original purchase value of $100,000.  I know, complicated…TMI.

 

In the retail businesses, inventory should be valued using FIFO – First-In-First-Out.  There are other methods used too such as LIFO – Last-In-First-Out and weighted average.  But nearly all retail inventory value should be based on FIFO.

 

Here is a simple example followed of how inventory is valued.  In month one 100 pieces of item A are bought at $1 a piece and in month two 200 pieces of item A are bought at $0.95 a piece.  So total inventory purchased is $290 [($1x100 pieces) + ($0.95X200 Pieces).

 

In month two 70 pieces are sold. In month three 100 pieces are sold.

 

FIFO

FIFO - First In First Out - is exactly what is says.  The first ones in the door are the first ones out the door.  Here the first ones in the door were purchase at $1.  So we remove 30 units @ $1 a piece from inventory at the end of month two.  That leaves $260 ($290 less $30 of ones sold) of inventory value. There are 230 pieces remaining in inventory (30 @ $1 and 200 @ $0.95.). 

 

In month three 100 are sold.  So 70 pieces of the first purchase were sold in month one, leaving 30 pieces remaining from the first purchase.  So the other 70 pieces out of 100 pieces sold in month 2 must come from the second purchase transaction, leaving 130 pieces of inventory which was purchased at $0.95 a piece.  The ending inventory value using FIFO is 130 pieces at $0.95 or $123.50.

 

 

LIFO

LIFO means Last In First Out.  The last piece in the door is the first piece out the door.  In other words, the 130 pieces in inventory is valued at first purchase price of $1.  There were 130 left.  So inventory value is $130, $6.50, more than the FIFO method.

 

WEIGHTED AVERAGE

Weighted Average is just that - adding all the purchases together and dividing by the total number of pieces purchase to derive an average.  In the example, 300 pieces were purchased for a total of $290.  The weighted average cost per piece is then $0.9667 ($290/300 pieces).  So if the ending inventory at the end of month three is 130 pieces, the inventory value would be $125.67. 

 

As one can see, inventory value can be an accounting challenge, not merely counting it, but valuing it. The agent needs to understand these methods and how they play into the deal.  Again, 98% of the deals will be valued using FIFO.

 

OTHER INVENTORY ISSUES

In the retail business, there is a certain amount of speculation an owner makes when purchasing merchandise.  The owner will attempt to predict consumer demand for any particular item and will stock-up accordingly.  But if the owner is wrong, then inventory becomes slow moving and even obsolete.  This inventory should be either significantly discounted in the sale or thrown out.  It should not be valued as part of the purchase price.  The seller and buyer must negotiate the deposition of such inventory. 

 

The owner should have reports showing the slow moving items, but if they don’t then use caution and have the buyer do a close visual inspection of the merchandise looking for aged items – dusty or discolored – showing they are slow moving.  These items must be removed from the inventory value.

 

INCOME DEALS – GOOD TAX RETURNS

If by chance a retail business has good tax returns, here are the average multiples used with Seller Discretionary Income.

 

CHART 3

MULTIPLES OF SELLER’S DISCRETIONARY EARNINGS ANALYSIS

 

                                                                        BizComps*               

Automotive Repair                                        1.9                                    

Beauty Salons                                               1.8                                    

Cocktail Lounges                                          2.6

Coin Laundry                                                 2.8

Convenience Stores                                     2.6

Deli’s                                                              1.9

Day Care Centers                                         1.9

Dry Cleaners                                                 3.2

Florists                                                           1.6

Food Markets                                                2.6

Liquor Stores                                                 3.8

Restaurants                                                   2.3

Service Stations                                            2.1

Video Store                                                   2.3

 

* Excludes Inventory

 

Source: Thomas L. West, The 1997 Business Reference Guide (Concord, Mass.: Business Brokerage Press, 1997), p. 323.  See Bibliography at the end of this chapter for information on Bizcomps.

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