Retail industry is very large and its well-being is essential to the health of the overall economy. As an example, the retail market segment represented by the US department stores, SIC 5311 and NAICS 452111, has over 3,500 establishments generating just under 76.9 billion dollars in annual revenues and employing more than 534,000 people.

Retail businesses come in all types and sizes – from a neighborhood specialty shop to large “formula store” chains owned by major multi-nationals. 

Major trends that affect retail business value

A number of important trends are clearly visible on the retail landscape:

  • Proliferation of “big box” retail chains.
  • Growth of franchise systems.
  • Emergence of the Internet as a viable way to reach many retail customers.

The continued advance of large chains has posed serious problems for many small retailers. Many successful stores now focus on niche markets that can be served profitably with a highly targeted product mix backed by excellent customer service – something that small businesses can do very well.

At the same time, franchise systems offer smaller retail operators a “safety in numbers” approach to competing against the large chains. Proven marketing strategies, product selection and good store management systems work to level the playing field.

Internet has come of age as a viable commerce channel. In addition to the “pure play” online businesses, many traditional retailers now have a presence on the Web, effectively becoming the  multi-channel “click and mortar” operations.

Retail business value drivers

Here are a few factors that affect the earning power and value of retail businesses:

  • Inventory is the largest investment. Efficient inventory management is a key differentiator for successful retailers.
  • Accounts receivable if the business offers credit.
  • Relatively high employee turnover. Pay rates are lower than in manufacturing industry.
  • Very strong location dependence.
  • Shift toward focus on niche markets as a way to combat “big box” competition.
  • Addition of services to gain pricing flexibility: “value-added” pricing advantage.

There is increasing use of modern POS (point of sale) and inventory management computer systems. These systems give small retail operators state-of-the-art ways to control costs, improve profitability and cash flow.

Effective inventory management reduces the working capital requirements, increases available cash flow and leads to higher business values.

Key success differentiators that add up to higher retail business valuations

1. Product mix and price. The retailer’s skill in developing a compelling product mix that is priced just right for the target market is key to creating repeat customers and traffic growth through referrals. And business growth prospects directly affect how much the business is worth.

2. Convenience such as store hours and location are critical to generating the foot traffic and developing customer loyalty. Repeat business tends to lower the marketing costs and smooth out the bumps in the business earnings – important business value enhancing factors.

3. Customer service. Nothing is more important to growing a solid repeat customer base than excellent service. Many small retailers realize this and make their stores into true destinations for the regulars. Superior customer retention tends to translate into lower operating costs and higher profit margins – and higher business value.

4. Store layout. Attractive, well organized store helps the customers stay longer and spend more money. Efficient use of the shop floor space results in higher revenue per square foot. Since valuation multiples based on store revenues are very common in valuing retail businesses, higher revenues tend to go with higher business values.

Key points to consider when valuing your retail business

1. Carefully recast your historic financial statements. Your goal is to demonstrate the true earning power of the business. Retail businesses are appraised based on cash flow, using seller’s discretionary cash flow or net cash flow as the earnings basis. Business cash flows can be very different from its profits!

2. Prepare an earnings forecast. As many a seasoned business broker will tell you, business buyers pay for the past, but buy the future. Not surprisingly, the business earnings prospects are more important when determining the business value, than its past financial performance.

3. Review the business asset base. Your cost-basis balance sheet may show asset values very different from their current fair market value. If you value a retail business using an asset-based business valuation method, you need to reconstruct the company’s balance sheet accordingly. Pay special attention to the values of inventory and furniture, fixtures and equipment.

Retail business valuation methods

As with any industry, you have quite a number of methods to choose from. A good practice is to use several methods under the standard Market, Income and Asset business valuation approaches. Here are a few suggestions that are very often used to value retail businesses: 

Market comparables

Given the retail industry size, it is not surprising that a number of closely held retail businesses change hands regularly. You can use the sales data to compare your business to similar businesses that sold recently. Such sales data is typically used to derive the so-called pricing multiples

The pricing multiples are ratios which relate the business selling price to its revenue, net sales, cash flow, net profit or EBITDA, and business assets. Using such multiples, you can estimate your business likely selling price, using your business financial parameters.

Multiple of Discretionary Earnings

This income-based business valuation method is a very good fit for valuing owner-operator managed retail shops. In addition to accounting for the business earnings and industry growth, this method lets you factor in such important business parameters as location, competitive environment, ease of operation, quality of the staff and overall desirabilty.

Capitalized Excess Earnings

Asset-rich retail businesses are frequently valued using this classical business valuation method. The method seeks to establish the business value as the sum: 

Business value = net tangible assets  + business goodwill

If you are looking to value an established business which has become a true “institution” in its market, Capitalized Excess Earnings is an excellent way to show the value of business goodwill.