It is easy to find the valuation of a public company. Simply calculate the market valuation and look at the current stock price. But how do you assess the value of a franchise business?
Unfortunately, there are no specific indicators to determine the value of small and privately held companies. Purchasing a franchise business requires a good understanding of various aspects of the business. I will discuss a few points here that I think are critical in determining the value of a small and medium enterprise.
”Find the franchise that is growing and opening new locations. Consult financial advisors who can help you build a picture of your financial strength. Seek out for friends and family members who have been in the franchise system.
In other words, there is more to investing in a franchise system than just the price.
HOW TO ASSESS THE VALUE OF A FRANCHISE BUSINESS?
Assuming both parties are knowledgeable, fair value is the sale price agreed upon by a willing buyer and a seller, not under duress. Here are some typical ways to calculate the value of the company.
1. P/E Ratio or Earnings x PE Ratio = Company value
The P/E ratio can be just 2 or 3 for a neighborhood liquor store, while it can be in thousands for tech or pharmaceutical companies who don’t even have a product to sell. If you look at the top 10 franchises, their P/E ratio will vary between 4 and 10. It will be less for businesses where the owner has to work, and it will be very high for businesses where the owner does not have to do anything. To make the same $100,000 the buyer has to pay $400,000 for a UPS Store but may have to pay $1,000,000 for a McDonald.
2. Book Value
The book value of a company is as the name suggests. You add every physical item a company owns and you get the Book value. It does not consider Goodwill, Brand, customer lists or patents as value. It works only for a very small operation. It is also very inaccurate. I have never seen people make deals on book value.
3. What is ROI (Return on Investment) for a business you are buying?
ROI is the most common profitability ratio (the net ratio between net profit and the cost of the investment). A high ROI means high profitability as compared to other similar uses of the same money. Typically a business owner would like to get 10 to 25% ROI on their investment. ROI is also calculated on real money invested in the business. If I have $400K, and I invest in a business that makes $100K every year, my ROI will be 25%.
Now let’s take another scenario. Suppose I purchase a business which costs 4 times more, but also makes 4 times net profit – in other words this business is worth $1.6M and nets $400K. If I invest $400K in this business and I get financing from a Bank at 5% for the remaining $1.2M, I will be paying $60K interest every year. But I will be making $400K – $60K = $340K every year. In other words, I will be making $340K every year on my $400K investment or an ROI of 85%. Using Bank money or seller financing typically increases ROI for the buyer. The same concept works when you take a mortgage on your home.
4. How is the cash flow?
Cash Flow is the summary of your income and expenses over a period, generally a month. The P&L Statement will show if your business made money or lost money over that period. There are various components of P&L Statements that I will explain in the next blog.
A franchise is a major investment. Find the franchise that is growing and opening new locations. Consult financial advisors who can help you build a picture of your financial strength. Seek out for friends and family members who have been in the franchise system. In other words, there is more to investing in a franchise system than just the price.