What is the top measure of financial performance that stands out in the retail industry? You may have heard of sales per square foot or SPF for short. Professional appraisers benchmark retail stores on SPF – and for a good reason:
- Floor space is expensive. Successful retailers utilize it to maximize their revenues. For each business concept there is a sweet spot square footage that works best.
- Retailers treat rent as a major operating expense. Rents in excess of 10% of gross revenue are a red flag.
- A retail shop with oversized floor space has a problem. Because it has to contend with high rental expenses and extra product costs to fill in the space.
- It takes more labor to service a larger than needed floor space. And this erodes the retail business profit margins.
Top valuation multiples for a retail business
Here is the short list:
- Business sale price to annual revenues, plus inventory.
- Business sale price to discretionary cash flow. Inventory is extra.
Given the importance of maximizing the sales per square foot, you would expect that the value of a retail business depends on its revenues. This is indeed the case – the most commonly used industry valuation multiple for a retail business is the business sale price to annual revenues.
If you see high returns and discounts in your business, consider using the business sale price to net sales valuation multiple.
The close second valuation multiple for private retail stores is business sale price to seller’s discretionary cash flow also known as the seller’s discretionary earnings or SDE for short..
The advantage of using this second multiple to value your retail business is that it measures your business worth directly on the amount of cash flow the business throws off.
Watch out: seller’s discretionary earnings is not net profit
A word of caution: do not confuse discretionary cash flow with business net profits. The discretionary cash flow is what the business puts in its owners’ pockets – which typically is quite different from the taxable business income.
A major mistake in retail business valuation
A major mistake in retail business valuations is applying the cash flow based valuation multiple to business net income or EBITDA. This is likely to result in your business being undervalued significantly!
With all the cost of goods and operating expenses a retail shop owner needs to handle, valuing your business on cash flow makes sense.
Other business valuation methods for retailers
If you need to value an owner-operator managed retail business, consider using the Multiple of Discretionary Earnings method.
This well-known method considers both the business cash flow and a number of critical financial and operational performance factors.
If your retail business is an established institution in its market, then you probably have built up considerable business goodwill.
Capitalized Excess Earnings valuation method, described in the Internal Revenue Service Ruling 59-60, is a recognized way to calculate your business goodwill and total business value.