Economic Approach to Business Valuation
The economic approach to business valuation places a strong emphasis on the return on invested capital (ROIC), typically referred to simply as “the return,” of a business investment. The financial return of a business is typically the biggest consideration a business buyer has when deciding if he or she should invest in a small business (as should be expected when investing tens or hundreds of thousands of dollars!).
It should be noted that a business seller will also typically weigh the return on invested capital they receive from their business investment that they own/operate when deciding if they should sell the business. After all, they would likely need to find a suitable replacement to what can be a very significant return. The findings of renowned author, speaker, business consultant, and accountant Greg Crabtree places the return on invested capital of a profitable business with 15%+ profitability in terms of net income at a minimum of 50%. More often than not, the return for a business of 15% or more net income is above 75%. How many investment opportunities exist where an investor can achieve a 50% annual return? (Hint: not many.)
Let us take a look at how the economic approach to business valuation is used in practice.
How is it calculated: profits divided by total investment in the business
When to use it: best company valuation method for existing businesses with 2-3 years of financial history available when the near term (2-5 years) economic outlook for the business looks steady
Pros
- Calculates the most important metric, return on invested capital, for the potential business buyer
- Can calculate easily if the right information is available
- Creates clarity for the business buyer to base their decision off of
- Most relevant for owner-operators
Cons
- Needs accurate historical financials to be useful
- Not suitable for startup businesses or businesses where the near-term economic outlook is unstable or declining
- Does require reference amounts, either the asking price or another calculated amount, to base the profits and/or total investment amount off of
Illustrative Example Business Case for Calculating Business Valuation Using the Economic Approach
The economic approach to business valuation can best be demonstrated by going through an example. In this scenario, the buyer, Tom, has spent some time reviewing existing businesses listings and has whittled down his choices. At the moment he is deciding between purchasing one of two existing business options. Option A is a pastry store called Isabel’s Pastry Shop. Option B is a fitness studio called Fred’s Fitness Center. As both businesses have been open for over three years with available historical financial data, Tom decides to value the businesses according to the economic method.
Below are the steps that Tom will take in order to calculate the value of each of the business options he is analyzing:
Step 1
(data collection)
Gather all of the historical data for each of the businesses, including business projections for the next five years.
Step 2
(review and forecast)
Review the financials, particularly the projections for the next five years to ensure that the forecasts of future cash flow are consistent with results from the past 2-3 years.
Step 3
(calculate return)
Based off of the projections, calculate if the investments reach the required rate of return on invested capital
Step 4
(decision)
Based off of the projected returns, decide if the investment is made or not
Calculating the Inputs
Step 1 (data collection)
Tom, the business buyer, requests the historical financials, including recent tax returns, profit and loss statements, balance sheet, cash flow statement, and projections of the business, in order to gain a better understanding of the business. Additionally, Tom requests profit and loss projections for the next five years from both of the businesses.
Step 2 (review and forecast)
With the financial data verified, Tom focuses much of his attention on the projections for the next five years. He knows that due to his prior experience managing successful small businesses that he can decrease costs and increase the sales for both of the businesses. However, he is more confident in his ability to operate Fred’s Fitness Center as he himself is a former fitness trainer with experience managing a gym.
Option A — Isabel’s Pastry Shop
| Projected Income | Year 1 | Year 2 | Total |
|---|---|---|---|
| Revenue | $500,000 | $550,000 | $1,050,000 |
| Cost of Goods Sold | $125,000 | $110,000 | $235,000 |
| Gross Profit | $375,000 | $440,000 | $815,000 |
| Labor | $150,000 | $170,000 | $320,000 |
| Rent | $100,000 | $103,000 | $203,000 |
| SG&A | $75,000 | $50,000 | $125,000 |
| Net Operating Income | $50,000 | $117,000 | $167,000 |
| Taxes (40%) | $20,000 | $46,800 | $66,800 |
| Estimated After Tax Cash Flow | $30,000 | $70,200 | $100,200 |
Option B — Fred’s Fitness Center
| Projected Income | Year 1 | Year 2 | Total |
|---|---|---|---|
| Revenue | $400,000 | $475,000 | $875,000 |
| Cost of Goods Sold | $140,000 | $166,250 | $306,250 |
| Gross Profit | $260,000 | $308,750 | $568,750 |
| Labor | $75,000 | $85,000 | $160,000 |
| Rent | $55,000 | $56,650 | $111,650 |
| SG&A | $35,000 | $45,000 | $80,000 |
| Net Operating Income | $95,000 | $122,100 | $217,100 |
| Taxes (40%) | $38,000 | $48,840 | $86,840 |
| Estimated After Tax Cash Flow | $57,000 | $73,260 | $130,260 |
Step 3 (calculate returns)
Tom then calculates the returns he believes he would receive based on the price each business is asking as well as the business projections he has made.
Option A — Isabel’s Pastry Shop
| Projected Income | Year 1 | Year 2 | Total |
|---|---|---|---|
| Revenue | $500,000 | $550,000 | $1,050,000 |
| Cost of Goods Sold | $125,000 | $110,000 | $235,000 |
| Gross Profit | $375,000 | $440,000 | $815,000 |
| Labor | $150,000 | $170,000 | $320,000 |
| Rent | $100,000 | $103,000 | $203,000 |
| SG&A | $75,000 | $50,000 | $125,000 |
| Net Operating Income | $50,000 | $117,000 | $167,000 |
| Taxes (40%) | $20,000 | $46,800 | $66,800 |
| Estimated After Tax Cash Flow | $30,000 | $70,200 | $100,200 |
| Purchase Price (Invested Capital) | $400,000 | ||
| Year 1 Return % | 8% | ||
| Year 2 Return % | 18% | ||
| 24-Month Return ($) | $100,200 | ||
| 24-Month Return % | 25% | ||
| Required Rate of Return | 50% | ||
| Meets Threshold of ROIC? | No |
Option B — Fred’s Fitness Center
| Projected Income | Year 1 | Year 2 | Total |
|---|---|---|---|
| Revenue | $400,000 | $475,000 | $875,000 |
| Cost of Goods Sold | $140,000 | $166,250 | $306,250 |
| Gross Profit | $260,000 | $308,750 | $568,750 |
| Labor | $75,000 | $85,000 | $160,000 |
| Rent | $55,000 | $56,650 | $111,650 |
| SG&A | $35,000 | $45,000 | $80,000 |
| Net Operating Income | $95,000 | $122,100 | $217,100 |
| Taxes (40%) | $38,000 | $48,840 | $86,840 |
| Estimated After Tax Cash Flow | $57,000 | $73,260 | $130,260 |
| Purchase Price (Invested Capital) | $250,000 | ||
| Year 1 Return % | 23% | ||
| Year 2 Return % | 29% | ||
| 24-Month Return ($) | $130,260 | ||
| 24-Month Return % | 52% | ||
| Required Rate of Return | 50% | ||
| Meets Threshold of ROIC? | Yes |
Step 4 (decision)
Based off of the return to each of the businesses, one of them, Fred’s Fitness Center, has significantly higher returns and exceeds the required return on invested capital that Tom needs in order to move forward.
Important note – the focus on this example was launch capital as it is the simplest to understand and calculate. In this example, the launch capital was comprised of the purchase price as it was assumed that the purchase price included fully capitalizing the business with the required buffer and trade capital.
Summary
The economic approach to business valuation is very useful in simplifying the investment decision for the business buyer. The business buyer can calculate the return on their invested capital based off of the financial projections. As the financial projections are key to the investment decision, the economic valuation method should be more utilized for businesses with an established track record as well as stable economic future rather than businesses that are extremely unstable or relatively new.
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