Archive for January, 2008

Hospitality industry continues to grow at a rapid pace. In addition to the major markets including business and luxury hotels, motels and country inns, recent growth has been fueled by the addition of privately owned establishments that tend to focus on lucrative niche markets. These include specialty bed and breakfasts, destination location inns, fitness oriented resorts, golf course and vacation properties.

Similar to other real estate based operations, hospitality businesses are cyclical in nature. Since much of their income is generated by renting the property, size truly matters.

An industry rule of thumb is that a property needs to have at least 10 rentable units to provide adequate returns for its ownership. Most small privately owned hospitality businesses fall into the 10 – 200 unit range.

Unique factors that drive hospitality business value

These businesses have a number of characteristics that have a major impact on their value:

  • They share the features of both business and real estate investment.
  • The business tends to be quite labor intensive.
  • Multiple profit centers are very common. In addition to property rental, restaurants, gift shops, fitness facilities and lounge are common.
  • Repeat and referral business is critical to revenue generation.
  • Rental rates are flexible and can be adjusted seasonally and even daily. Successful hospitality operators are quite skillfull in packaging their product to reduce vacancy rates.
  • Aggressive and continuous advertisement is essential.
  • Effective online presence is increasingly vital, including participation in reservation systems and membership in destination marketing organizations.
  • Capital requirements are quite high.
  • Businesses demand competent, hands-on management.

Buying a hotel or motel: key success factors

If you review what makes business acquisitions in the hospitality industry successful, you will find that they tend to share a few traits in common:

Determining the business value

When valuing a business in this industry, you should consider these essential elements:

  • Property expansion potential. In hospitality industry, business revenues are derived from rent, which is driven by property size.
  • Equipment condition and maintenance status. Watch our for deferred maintenance expenses.
  • Location. Needless to say, this has direct impact on the business earning potential – both in terms of room rent and vacancy rates.
  • Access to acquisition or expansion capital.

That said, you have 3 ways to value a business in this industry:

  1. Cost (Asset) approach.
  2. Market approach.
  3. Income approach.

Cost approach to business valuation

The basic idea behind the asset based business valuation is this: business value equals the current property replacement cost less an allowance for physical, functional and economic obsolescence.

Note that cost based business valuation does not account for the business earning capacity or risk.

Market approach to valuing a business

Under the market approach to valuation, you determine the business value in comparison to actual selling prices of similar properties. Since many private hospitality businesses are quite unique, meaningful comparison may be a challenge.

Business valuation based on income

Under the income valuation approach, you have a number of capitalization and discounting methods to valuing a business. Typical ways to estimate business value are multiples of gross rental income and net operating income. You need to factor in both the property rental income as well as earnings from the other profit centers, such as the restaurant or on-the-premises gift shop.

Multi-year financial analysis is the choice of savvy business investors. A key factor which determines business value is the internal rate of return.

Capitalization rates vary across the business types in the hospitality industry. Typical values are in the 11% – 14% range.

If you need a reliable business value estimate, it is a very good idea to combine the results from several business valuation methods.

Brand names and trademarks are an important type of business intangible assets. Most successful businesses have these valuable assets in one form or another. Think of business trade names or product and service trademarks used to distinguish business offerings in the competitive market place.

As a business builds customer following, the value of its brand names grows. Existing customers prefer products they know – and often identify them by name. New referrals often come to the business to check out a product – because they were given its name.

Yet, the accounting balance sheet does not show that brand names have any value. If the business owners did not acquire them from a third party, the brand name is not listed at all!

But when it comes to valuing the business, brand names and trademarks quickly surface as the major value contributors. So how can you determine what these assets are worth?

You have 3 ways or approaches to measure the value of any business asset: Cost, Market, and Income. Let’s see how each can help in valuing business brand names.

Market valuation approach

Valuation using market based methods relies on comparison with sales of similar assets. The trouble is there just isn’t enough sales to compare against. Brand names and trademarks rarely sell by themselves, rather the entire business changes hands.

Cost valuation approach

Here you determine the value of a business intangible asset by estimating the cost of re-creating a similar asset. Since brand names are quite unique, re-creating them from scratch is very hard.

You can estimate the costs of designing a similar product, its manufacturing and distributions facilities. But how much will it cost to develop the same customer recognition and loyalty? The answer is at best speculative – which makes the cost approach hard to apply.

Income valuation approach

This leaves you with the income based valuation methods. The idea is this: if you can attribute income to the brand name, then its value can be measured. You can do this using a number of well-known discounting or capitalization business valuation methods.

Looking at the income generated by the brand name product seems like a good choice. However, many other business assets also contribute to this income: production facilities, sales, marketing and customer support efforts.

What you need is a way of isolating that part of business income that is due to the brand name itself. There are a couple of ways to do this:

  1. Incremental income method
  2. Royalty income method

Incremental income valuation method

Brand name products tend to sell in higher volume and at a higher price than their generic counterparts. You can observe this “income lift” effect of a brand name by estimating two key factors:

  1. Incremental sales volume increase of a brand name product when compared to generic products.
  2. Incremental price increase that a brand name product commands in its market.

Together, these two factors are responsible for the additional income that can be attributed to the brand name directly.

Royalty income valuation method

Valuable Brand names can be licensed to another party. Such a licensing arrangement brings income in the form of royalty payments. Royalty rates are highly negotiable but in general are set as a percentage of expected sales. For example, if the licensee projects $1,000,000 in sales using the licensed brand name for products, then the licensor may collect  5% or $50,000.

Hence, you can value the brand name based on the expected royalty income. This requires accurate sales forecasts and agreement on a suitable royalty rate. Once these two parameters are determined, you can calculate the brand name value by discounting the income stream at an appropriate discount rate.

An alternative: relief from royalty valuation method

If you need to determine the brand name value but have no plans to license it to anyone, you can use an alternative method. This method is called relief from royalty.

The basic idea is to assume that, if the brand name were to be acquired, you would need to make adequate royalty payments. Since the business already owns the brand name, it avoids the costs of royalty payments.

Being relieved from this financial burden generates additional income that flows to your bottom line. The present value of this extra income is the value of the brand name.

One of the benefits of using asset based business valuation methods is that you can see how each business asset and liability contributes to business value. This is very useful for a number of important reasons:

  • Estimation of business value for tax purposes. 
  • Business purchase price allocation.
  • Determination of which business assets are available as part of business sale.

To use the well-known asset accumulation method to value your business, you start with the current balance sheet. You then adjust this cost-basis data, accounting for off-balance sheet items and estimating the fair market values of business assets and liabilities. The difference is business value.

One of the important adjustments is determining the value of business long-term liabilities. A typical example is a commercial bank loan. Business management may have negotiated the terms of such financing some time in the past. As financial market conditions change, so do the terms of such loans.

So how can the terms of debt financing obtained awhile ago affect what your business is worth today? Let’s take a look at an example.

Example: favorable financing and business value

Suppose that you have a commercial bank loan with $250,000 balance and a 10 year term at an attractive 4.75% fixed annual interest. Under this arrangement your yearly payment, including both principal and interest, is $31,454.32.

If you were to raise this loan today, your bank would charge you around 7.75% interest. This would mean an annual payment of $36,003.19. By financing debt at the lower 4.75% rate, your business saves $4,548.87 each year.

This effectively lowers the present value of the loan. And since your business value is calculated as the difference between the present values of the business assets and its liabilities, such favorably financed debt works to increase your business worth. 

You can account for this business value-enhancing effect of lower cost debt financing as follows:

  1. Start with your current annual payment of $31,454.32.
  2. Discount this payment stream at the current market rate of 7.75%.
  3. Calculate the present value of the debt. This is what the favorably financed loan is worth today.
  4. Subtract this amount from the fair market value of business assets.

Using ValuAdder Loan Schedule and Discounted Cash Flow calculations you find that, instead of $250,000, the commercial loan is worth only $213,461.86 today. Other things being equal, this contributes $36,538.14 to your business value.

Whenever you value a business based on income, you need to address two questions:

  1. What are the business earnings likely to be in the future?
  2. What level of risk is associated with getting these earnings on time and in full measure?

Financial forecasts are a typical way to estimate future business income. The goal is to project earnings for some period of time. You can then discount this income stream to get your business valuation as of today.

Obviously, your results will depend on how realistic your financial forecasts are.

Many financial projections assume a constant growth rate, often based on the business historic track record. For example, a 5% revenue growth rate may be used to forecast future business sales levels.

Business financial plans also assume that some costs are fixed. This can make the business projected earnings picture look rosier every year. 

This type of forecast may have serious drawbacks that can result in unrealistic business valuation results.

For one thing, constant business growth rates are rarely seen in the real world. External events beyond the business owners control affect business financial performance.

Think about the political upheavals such as 9/11 and its effect on personal safety and stability of the capital markets. Or the rise of the Web and the emergence of social networking, e-commerce and search engine marketing.

If we look back past year 2000, many of the changes affecting businesses today could hardly be foreseen.

A 5-year horizon for your financial projections is a reasonable limit to handle this level of uncertainty. Your business valuation would be more accurate because it relies on shorter period forecasts – validated by more likely near-term events.

AICPA has finally done it! After years of work, the latest Statement on Standards for Valuation Services (SSVS No. 1) has been adopted as of January 1, 2008.

While upholding the substance of the earlier USPAP business valuation and reporting standards, SSVS No.1 introduces several new definitions and requirements for professionally prepared business appraisals.

Business valuation engagements

Professional business appraisers and their clients can choose between two main types of business valuation engagements:

  1. Calculation engagement
  2. Valuation engagement

The key difference between the two is in the choice of business valuation approaches and methods.

In a calculation engagement, the business appraiser and client agree up front what business valuation methods will be used to calculate business value.

Under the valuation engagement guidelines, the business appraiser is responsible for choosing all the business valuation methods. The appraiser then uses the results from the different methods to come up with the business value – either as one number or a value range.

See an example of how to do this in Step 5 of the business valuation process: reaching the business value conclusion.

Business valuation report formats

Under SSVS No. 1, the different types of business valuation engagements can be reported in a number of formats.

Calculation engagements are reported in a calculation report. Valuation engagements can be reported in either of the two formats:

  • Detailed report
  • Summary report

Both types of business valuations can be reported in an oral report format.

Here are the key elements that should appear in a Detailed Report:

  • Letter to the client which accompanies the report
  • Table of report contents
  • Introductory sections
  • Information sources used in business value analysis
  • Non-financial information analysis affecting the business being valued
  • Financial statement analysis and adjustment for business valuation
  • Business valuation approaches and methods considered and selected
  • Reconciliation of the different business valuation method results to conclude business value
  • Representation and professional qualifications of the business appraiser
  • Supporting information such as appendices and exhibits

With ValuAdder business valuation software you have complete flexibility to choose from a number of standard business valuation methods under all three approaches: Asset, Market, and Income.

This enables you to address your specific business valuation needs and meet either the SSVS No. 1 calculation or valuation engagement requirements.

The Business Valuation Report Builder includes important language expected of SSVS No. 1 compliant business appraisal reports.

And you can use the power and flexibility of a fully editable Microsoft® Office Word template to complete your business valuation reports in record time!