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June 2005
What
is a business worth? 
You're forever learning in this real estate business
-- or at least you ought to be doing.
Every contact, every showing, every offer, every potential transaction
(whether it comes together or not): each and every one of them can
teach you something. No two days are alike. No two situations
are the same. Whatever else can be said -- and often is! -- about
the real estate business, it is not a boring one.
I was reminded of all this just a couple of weeks ago when I was browsing
some Las Vegas websites. (And in case you're wondering why I was
so engaged, let me admit that I'm in the throes of talking to someone who's
interested in buying a casino there for [gulp] a billion dollars.
True, chance is a fine thing, but you never know, you never know, do you?)
Anyway, in the course of my searches I stumbled across a quite provocative
discussion of how the value of a business can be determined. You
can -- if you're prepared for some fairly intensive reading -- go to the
site yourself, which you'll find at http://www.fminevada.com/packaging.html.
Suffice to say here, though, that the author is no respecter of standard
appraisal methods. He has decided reservations about the efficacy
of the Comparative Market Analysis, Replacement Cost, and Income Capitalization
approaches, all three of which are commonly used to decide what a business
is worth to either a seller or a buyer. His argument -- with some
justification in my view -- rests on two main points. On the one
hand, it's a recognizable fact that no two businesses are truly comparable.
Each has its special differences and these explain its existing degree
of success (or lack of it). And on the other hand, appropriate weight
(or perhaps a reduction of it) needs to be given to several factors that
impinge upon the levels of profitability and viability, both under the present
ownership and management and if taken over and run by someone else.
Allowing for
the uncertainties
Although some sense of value
can be obtained by using one or more of the usual appraisal methods, the
author maintains that due account needs to be taken of eight assumptions
that may not apply when a change of ownership occurs:
1. The business is a going concern
2. Economic conditions are favourable
3. Specific industry conditions are satisfactory
4. Competition isn't a threat
5. Management has sufficient experience and expertise
6. Location is appropriate
7. Earnings are commensurate with the risk
8. Business records are accurate.
Obviously, all
of these factors reflect policies, procedures, and the utilization
of resources as they are under the current owner's control. However,
they may not remain the same when a new owner takes charge of the enterprise
-- nor do they have to do so. Moreover, external influences may
-- and can -- play their part, especially with regard to points
2, 3, and 4. Thus, deciding what a business is worth in its present
form is, at best, only an indication of what lies ahead. In addition,
it needs to be tempered by an awareness of what could or could not
occur down the road.
Assessing
the risk
As an extension of point 7, the author offers a worthwhile table of
the risks involved in different business ventures. (And it's perhaps
time I identified him as Robert W. Burley, President of Financial
Marketing Inc., Las Vegas.)
The determining factors, he points out, are the amount of skill and
training required; the type of business and industry involved;
the relative supply and demand of sellers and buyers in the particular
field of endeavour; and the length of time needed to recover the
investment it takes to assume ownership.
These can imply more or less minimal risk in such cases as hot dog
stands, ice cream shops, and snack bars. None of these call for
much prior experience or any significant purchase price. Nor are they
or the potential buyers of them a rarity in the market place.
At the other end of the scale are the likes of machine shops, manufacturing
plants, and medical laboratories. All of these suggest a need
for sufficiently qualified personnel; enough familiarity with the
end products and the market for them; probably a healthy
investment; and, like as not, some scarcity of buyers and sellers.
Between the two groups are numerous retail stores that vary in the need
for owners and staff to have the requisite product or service knowledge
and experience. For example, dollar and variety stores primarily
call for behind-the-counter skills and some ability to buy and stock the
right merchandise. In contrast, auto-parts and hardware stores need
more knowledgable people to run them, while the success of a restaurant
mainly depends upon cooks and chefs who can do a whole lot more than throw
a hamburger on the grill. Nevertheless, within this mid-range, in
which purchase prices can run from moderate to fairly significant, there
are usually enough sellers and buyers to provide for a market turnover.
Arriving
at some conclusions
It would be nice to think that all these quite valid points lead to
a simple formula for calculating the true worth of a business. Such,
though, -- and I'm sure it doesn't come as a surprise -- is not the
case. Rather, the consequence is an addition to the wisdom of taking
a decidedly sceptical view of what's showing in the books of a business
that's for sale.
This isn't to say that the financial statements are meaningless.
Far from it. Indeed, they can become particularly meaningful if you
run them through Robert Burley's "what if" questions and, as it were, slot
them into his risk table.
Nevertheless, perhaps herein lies both the one essential difference
and the clear similarity between appraising a residential
property and putting a value on a commercial one.
In theory, house values are easy enough to measure. You
have only to see what else is available -- or has recently sold -- at the
same sort of price. In this sense, subjectivity has little to do with
whether a buyer will buy or a seller will sell. It surfaces only
when there are bidding wars or there's greater motivation (we gotta
have it / we gotta sell it) on one side of a potential transaction
or the other.
Commercial values, however, are more difficult to determine.
True comparisons are more an exception than the rule and, although it's
commonly believed that an objective analysis is the basis for deciding whether
or not to purchase a business, the actual requirement is a healthy dose
of subjective judgement. The financial records are at most a beginning
and the interpretation of them is objective only in the sense of being
hardnosed, unmoved by emotion, and based on statistical evidence and projections.
Deciding the
outcome
If in this dissertation (because that's what I think I'm coming up
with this month!) I appear to be indulging in some hairsplitting, I suppose
it merely lends support to three other thoughts about the worth of
something -- or indeed anything.
For example, the economists favour what they call The Marginal Theory
of Value. This explains why people will buy one thing instead of
another. The decision is based on how much -- or less -- benefit
(e.g. need satisfaction / problem solution / whatever)
can be derived from one product/service or another.
Beyond this is the well known Law of Supply and Demand that, if everything
else is equal, undoubtedly sets the prices of things.
Reflecting both of these influences, the real estate industry refers
to what it calls The Principle of Substition: people are unlikely
to pay more for a property than a similar one would cost them.
And the marketing people liken it all to the WIIFM idea: What's
In It For Me?
But my own experience tells me yet another thing: that the real
test is how much/little a buyer will pay and how much/little will a
seller accept.
Which kind of has me leaving off where I came in. Whatever else
it it, the real estate business is far from cut and dried. It's
teaching you something every single day.
However, on my way out,
perhaps I ought, ahem, to mention one other thing.
If you happen to have a spare billion dollars you don't know what
to do with, I'm starting to think I could find a casino for you!
Duncan Pollock, Real Estate Broker,
427 Gate Street, Niagara-on-the-Lake,
Ontario, Canada L0S 1J0
Tel: 905-468-3154 Fax: 905-468-3812
Cellular: 905-704-9037
email: duncanpollock@sympatico.ca
Note: E-mail
addressed changed as above on Nov 3 2007
website: http://www.duncanpollock.com
PS. One
of my web pages provides a list of the other newsletters I've sent out. If
you choose to go to it, you can click on any title to bring up its full
text.
PPS. I've recently been invited and encouraged to create a second
website, one that deals with my approach to the industrial, commercial,
and investment real estate market. You can reach it, if you're so inclined,
at http://www.iciniagara.com.
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