Cost vs Return
Discussion
I wasn't sure if here or business might be better but I can't find the answer to a question I have. Of course, I might be phrasing the question wrong which is why I can't find an answer!
So onto my question. When buying an asset that has a financial return, over what time period (on average) should I be looking for that return to cover the initial outlay to purchase the facility that provides the income? Is there any kind of rule of thumb for different domains or is it simply (on average, approximately, wet finger in the air, YMMV, etc) 5x, 10x 15x the annual income equating to the overall purchase price? What if there is also an ongoing renewal of items required, ie something with a 30 year lifespan which need to be replaced to keep the output viable?
I've tried Googling but can't seem to find the style of answers I'm looking for. Most answers come up as earnings per share or something along those lines, which of course varies wildly!
If the domain is important, it is a food based domain, ie growing and selling produce.
So onto my question. When buying an asset that has a financial return, over what time period (on average) should I be looking for that return to cover the initial outlay to purchase the facility that provides the income? Is there any kind of rule of thumb for different domains or is it simply (on average, approximately, wet finger in the air, YMMV, etc) 5x, 10x 15x the annual income equating to the overall purchase price? What if there is also an ongoing renewal of items required, ie something with a 30 year lifespan which need to be replaced to keep the output viable?
I've tried Googling but can't seem to find the style of answers I'm looking for. Most answers come up as earnings per share or something along those lines, which of course varies wildly!
If the domain is important, it is a food based domain, ie growing and selling produce.
S6
I think what you are struggling to find is the Net Present Value. This is the discounted rate of future cash flows. Google it.
Every industry has a different benchmark according to risk and sustainability of income... Sometimes value is expressed as a multiple of sales in well defined businesses e.g. a convenience store. But more often than not it is expressed as a multiple of gross margin or net margin.
The most simplistic and risk averse buyers use a 1, 2 or 3 year payback on purchase price ... More established and predictable busineeses can command 6, 7, 8 x net margin...
If the business has significant brand equity... expect to pay considerably more again...
Hope this helps
Cheers
A
I think what you are struggling to find is the Net Present Value. This is the discounted rate of future cash flows. Google it.
Every industry has a different benchmark according to risk and sustainability of income... Sometimes value is expressed as a multiple of sales in well defined businesses e.g. a convenience store. But more often than not it is expressed as a multiple of gross margin or net margin.
The most simplistic and risk averse buyers use a 1, 2 or 3 year payback on purchase price ... More established and predictable busineeses can command 6, 7, 8 x net margin...
If the business has significant brand equity... expect to pay considerably more again...
Hope this helps
Cheers
A
Really difficult question to answer without a lot of specifics on the actual business.
In short, a multiple of the earnings where the multiple is generally defined by the sector average. But, if this is a small business then that can go out the window.
You need to know where the specific value of the business lies. For example, you wouldn't want to pay for the location necessarily, or you may have to discount because of revenue losses likely due to current owner leaving. Then there is growth potential. Does this business automatically increase in value by you taking ownership. What is the growth curve for revenues etc? Then you have to factor in the risk of change of ownership and all that.
I would guess that for most small businesses the value is less than 1 times annual earnings. And I'd consider earnings to be be profit plus salaries. And tangible assets I would just value at what they were worth to sell in a day, which is usually nothing.
In short, a multiple of the earnings where the multiple is generally defined by the sector average. But, if this is a small business then that can go out the window.
You need to know where the specific value of the business lies. For example, you wouldn't want to pay for the location necessarily, or you may have to discount because of revenue losses likely due to current owner leaving. Then there is growth potential. Does this business automatically increase in value by you taking ownership. What is the growth curve for revenues etc? Then you have to factor in the risk of change of ownership and all that.
I would guess that for most small businesses the value is less than 1 times annual earnings. And I'd consider earnings to be be profit plus salaries. And tangible assets I would just value at what they were worth to sell in a day, which is usually nothing.
Edited by DonkeyApple on Wednesday 18th February 07:49
You are asking how to value a business which is what I do all day.
It is not straightforward for big businesses let alone for small businesses.
Whenever I try to apply sensible valuation methods (say ROIC>WACC within 3 years) to small businesses it usually gets blown out the water by one or all of:
1. Massive profit volatility.
2. The owner also working for the business and not charging himself a salary.
3. The owner having some absolutely mad value in his head that bears no relation to the real world.
In reality if you are looking to invest in a small business you need to be pretty sure about the following:
- What you would do with the money otherwise (and the tax implications).
- How much time you want to spend on the business (and what your time is worth).
- Risk that you lose everything.
Regarding the capex question (replacing bits over 30 years) you need to have a sense of the ongoing annualised total maintenance spend as that tells you what a "normalised" profit will be over the longer term.
It's no good seeing huge profit over the last three years if four years ago the business spent $$$ buying 10 tractors that only last 5 years.
That should be accounted for in the depreciation but often you can fudge those numbers.
It is not straightforward for big businesses let alone for small businesses.
Whenever I try to apply sensible valuation methods (say ROIC>WACC within 3 years) to small businesses it usually gets blown out the water by one or all of:
1. Massive profit volatility.
2. The owner also working for the business and not charging himself a salary.
3. The owner having some absolutely mad value in his head that bears no relation to the real world.
In reality if you are looking to invest in a small business you need to be pretty sure about the following:
- What you would do with the money otherwise (and the tax implications).
- How much time you want to spend on the business (and what your time is worth).
- Risk that you lose everything.
Regarding the capex question (replacing bits over 30 years) you need to have a sense of the ongoing annualised total maintenance spend as that tells you what a "normalised" profit will be over the longer term.
It's no good seeing huge profit over the last three years if four years ago the business spent $$$ buying 10 tractors that only last 5 years.
That should be accounted for in the depreciation but often you can fudge those numbers.
^^^^ All true.
A similar question you see asked from time to time on PH is "how much does it cost to build a car?". This is massively hard to answer as can be easily demonstrated.
Imagine a factory can build a maximum of 100 cars a year and has been selling 99 a year for many years. But last year they managed to build/sell 100 and a huge proportion of the selling price of that car was pure profit. Excellent! But this year they have orders for 101 cars and believe future orders will continue to grow so they decide to build a new factory. How much does it cost to build that 101st car?? The answer is £££millions.
Investing in factories is tough, because you have to buy the WHOLE factory before you can build ANY cars.
A similar question you see asked from time to time on PH is "how much does it cost to build a car?". This is massively hard to answer as can be easily demonstrated.
Imagine a factory can build a maximum of 100 cars a year and has been selling 99 a year for many years. But last year they managed to build/sell 100 and a huge proportion of the selling price of that car was pure profit. Excellent! But this year they have orders for 101 cars and believe future orders will continue to grow so they decide to build a new factory. How much does it cost to build that 101st car?? The answer is £££millions.
Investing in factories is tough, because you have to buy the WHOLE factory before you can build ANY cars.
Folks,many thanks so far. All good research material!
Andrew - no brand equity.
Donkey - no chance of growth - it is a fixed size and unless I buy 'more', its set where it is.
Walm - ROIC I can understand. Current estimated return PA is 5% but this does not take into account the need to replace items in 5-10 years which has quite a considerable cost (currently at least 50% of 'requested' purchase price!). I faltered a bit at WACC as I don't know some of the values etc.
Claudia - I see your point but there are no major fixed assets or capital assets as such, other than the items I'm considering buying.
Walm - mind if I PM you for a bit more 'back of a fag packet' advice please?
Andrew - no brand equity.
Donkey - no chance of growth - it is a fixed size and unless I buy 'more', its set where it is.
Walm - ROIC I can understand. Current estimated return PA is 5% but this does not take into account the need to replace items in 5-10 years which has quite a considerable cost (currently at least 50% of 'requested' purchase price!). I faltered a bit at WACC as I don't know some of the values etc.
Claudia - I see your point but there are no major fixed assets or capital assets as such, other than the items I'm considering buying.
Walm - mind if I PM you for a bit more 'back of a fag packet' advice please?
S6PNJ said:
Folks,many thanks so far. All good research material!
Andrew - no brand equity.
Donkey - no chance of growth - it is a fixed size and unless I buy 'more', its set where it is.
Walm - ROIC I can understand. Current estimated return PA is 5% but this does not take into account the need to replace items in 5-10 years which has quite a considerable cost (currently at least 50% of 'requested' purchase price!). I faltered a bit at WACC as I don't know some of the values etc.
Claudia - I see your point but there are no major fixed assets or capital assets as such, other than the items I'm considering buying.
Walm - mind if I PM you for a bit more 'back of a fag packet' advice please?
PM by all means but even without the capex issue that isn't a great return IMHO.Andrew - no brand equity.
Donkey - no chance of growth - it is a fixed size and unless I buy 'more', its set where it is.
Walm - ROIC I can understand. Current estimated return PA is 5% but this does not take into account the need to replace items in 5-10 years which has quite a considerable cost (currently at least 50% of 'requested' purchase price!). I faltered a bit at WACC as I don't know some of the values etc.
Claudia - I see your point but there are no major fixed assets or capital assets as such, other than the items I'm considering buying.
Walm - mind if I PM you for a bit more 'back of a fag packet' advice please?
Be happy to take a look with the all-knowing fag packet
.Oh also WACC for you personally is more like an opportunity cost issue.
So for example, if I knew I could bung £XXXk into a buy-to-let and generate say a 5% net yield with capital appreciation potential then my "hurdle rate" for a competing investment would have to match at least that.
Possibly higher if I used some leverage.
Now clearly you pay a good chunk of tax on that rental yield (no tax shield without and ISA/SIPP wrapper) and you may be able to enhance your personal returns by paying yourself through a dividend or whatnot (ask Eric) but broadly speaking I think of potential investments as competing with each other rather than deriving a somewhat fictional WACC that doesn't apply in the real world. (e.g. the long term risk free rate is close to 4ppt but you won't find anything like that out there today.)
Edited by walm on Wednesday 18th February 18:37
S6PNJ said:
Current estimated return PA is 5% but this does not take into account the need to replace items in 5-10 years
Ouch! You'd have trouble persuading me to invest in that one.Many businesses use 20% return as a starting point. It's not always an easy target to achieve but does give room for survival if reality falls short of budget/hope/projection.
Claudia Skies said:
S6PNJ said:
Current estimated return PA is 5% but this does not take into account the need to replace items in 5-10 years
Ouch! You'd have trouble persuading me to invest in that one.Many businesses use 20% return as a starting point. It's not always an easy target to achieve but does give room for survival if reality falls short of budget/hope/projection.
S6PNJ said:
Ha ha ha - true but think about this more as pocket money and less as a main business! It certainly doesn't generate an income I could live off!
But at 5%, with the need to re-invest and carrying the default risk and work of any business, out of interest what would be the point of putting any money into it when it's possiblento get better yield for less risk?I can see the point of you're ablento either strip out costs to increase the return or expand to generate economies but if the plan is to leave as is then buying a laundrette under a council block would make more sense?
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