The True Value of a Business

Recognizing the true profit potential of a business based upon facts requires a comprehensive understanding of the industry, the brand and the specific business, regardless of whether it is 100 units or a single unit.  

Some time ago National Franchise Sales listed a restaurant opportunity with annual sales of around a million a year but showing only twenty thousand dollars in profit.  

The unit had been purchased by a franchisee living well out of the market and had been purchased years earlier for his nephew.  Shortly after taking over the store, the nephew discovered that he did not like the business and gave up managing the business, leaving the owner with a business over a hundred miles away with no manager to run it.  

This building was an overly large conversion. Being a restaurant guy, I was curious about this business, and I arranged to meet the absentee owner at the store one Saturday.  

The franchisee and I sat down for a cup of coffee about 11AM, and as I had never been behind the counter for this brand, I wanted to see how the store was laid out so asked the owner if he would mind giving me a tour of the back of the house.   

As we stepped into the back of the store, I told the seller that I noticed that the parking lot lights were still on when I pulled in. He said that he did not know where the switch was, so I told him “No problem, I will stand at the back door, and you can hit each circuit and I will tell you when the parking lot lights go off.”   

He responded, “no Alan, you don’t understand, I don’t know where the circuit breaker is” - the owner was so removed from the business he did not know anything about the store or how it was run.

On another visit to the store, I observed a cook loading a case of hamburger patties and buns into the trunk of his car.  Later, upon checking with the local police department, I learned that the store had a lot of criminal activity with drugs and prostitution occurring at the restaurant.  

NFS sold that store for $300,000 and obtained an SBA loan for 80% of the purchase price.   

That store was running a food cost of 38% at a time when the normal food cost for the brand was 26%.  It was a full 12% higher than the norm!  

If the store had only $20,000 in profit, was it sold for a multiple of 15 times profit?   

Or, given that the profit should have been 12% more of $1,000,000 ($120,000), was the true profit potential $140,000 ($20,000 plus $120,000)?  Thus, was it sold for a little over two times its annual profit?  

The answer is neither.  As this example reveals, you cannot attempt to value a business merely by a measurement of a multiple of profit.   

Recognizing the true profit potential of a business based upon facts requires a comprehensive understanding of the industry, the brand and the specific business.   Experience Matters.