Why Calculating Business Value Based on Turnover Paints An Incomplete Picture

Business valuation is the process of determining the economic value of a business or company, and it is an essential step in the merger & acquisition process. An impartial valuation of the target business by an external valuation firm assists both buyers and sellers in determining the business’s fair market value and negotiating a fair selling price. Both parties often want a quick number so they can proceed with the transaction and will ask for the business value based on turnover. However, this measure of value is woefully incomplete. AVGI presents three compelling reasons not to rely solely on business value based on turnover in determining the value of a company.

Understanding Turnover in a Valuation Context

The term turnover has three main implications in business:

1. Inventory turnover- how often the business is selling its existing inventory and purchasing more new inventory. High inventory turnover is positive and indicates well-managed inventory and excellent sales performance.

2. Cash turnover is similar to cash flow; this is how quickly the business spends its available cash over a specified time period. High cash turnover can be neutral to negative, depending on the industry (some industries are by nature more cash-heavy, so this metric must be viewed within an industry context to be interpreted accurately). However, very high cash turnover can indicate poorly managed revenues bleeding to unchecked business expenses.

3. Employee turnover is an important metric that reflects the efficiency and effectiveness of a business in managing its resources, including inventory, cash, and employees. Recruiting, hiring, and training new employees are huge expenses for companies, and high employee turnover rates indicate that those costs are consistent and recurring. While some industries struggle more with turnover than others, the fact is that high employee turnover rates eat into profit margins and impact company value.

Using turnover as the focal point in valuation practically means valuing the business based on revenue. Revenue is a fundamental factor in business valuation as it reflects the top line of a company’s financial performance. Revenue growth rate and predictability are essential characteristics of profitable businesses, and a turnover-based valuation benchmarks how close or far the business is from those revenue goals.

How to Determine Value Based on Turnover

This calculation involves using the appropriate revenue multiple for the business and multiplying the average weekly sales by the revenue multiple.

For example, a local coffee shop with average weekly sales $5,000 wants to know its value based on turnover. If the revenue multiple for coffee shops in the region is typically 1.5, we would calculate the business value as follows: 

Business Value = Average Weekly Sales x Revenue Multiple

Business Value = $5,000 x 1.5 = $7,500. 

Therefore, the value of this coffee shop, based on its turnover, would be approximately $7,500.

Identifying the Revenue Multiple

The revenue multiple is a key factor in income-based valuations, and it varies based on the industry, market trends, and growth potential. A higher revenue multiple indicates a higher business value, while a lower multiple indicates a lower value. The choice of revenue multiple depends on the business’s industry, annual revenue, profit margins, and growth potential.

3 Ways the Turnover Valuation Method Falls Short

1. Overly Simplistic Approach

This quick back-of-the-napkin valuation provides but a glimpse of one aspect of how the business is performing. It fails to encompass enough data to even represent a full picture of all turnover in the business. For example, this number gives zero information or insights into employee turnover rates and does not even factor it in, contrary to what the name of the valuation would seem to indicate.

2. Many Other Factors Affect Business Value

There are myriad other factors that impact a business’s value besides turnover. Even when comparing two businesses in the same industry with particularly high churn rates, turnover is a single factor to examine in the grand scheme. Let’s examine some of the other factors that influence a business’s worth:

1. Industry Trends, including economic shifts and consumer behavior

2. Market Competition- are rising competitors threatening the business’s potential earnings/market share?

3. Recurring revenue- what percentage of the company’s revenue is reliably recurring vs what percentage is seasonal or sporadic?

4. Cash flow- how stable is it? Is money coming in at regular intervals? Are business expenses reasonable and lower in proportion to revenue?

5. Independence from the owner or other key individuals- can the business survive if those key individuals would leave or retire? Or is the business overly dependent on them?

6. Operational Efficiency- Are business processes smooth and seamless to facilitate maximum output and revenue, or are kinks holding up the system?

7. Intangible assets, such as intellectual property and brand reputation, also contribute to a business’s value.

These points along with other relevant factors all play a part in shaping a business’s current worth on the market. When each factor is examined as part of the larger business ecosystem, it lends itself towards producing a more accurate valuation result.

3. Industry Multiples are Inaccurate Measures of Current Market Trends

The turnover method relies heavily on industry-specific multiples. However, these multiples are slow to change in response to changing market conditions, which can significantly skew results. This is particularly true if the industry is experiencing an unusual slump or spike in activity. For example, the screeching halt to the travel industry at the start of the COVID-19 Pandemic was a significant market change that would clearly impact the value of a travel agency at that time. However, valuing a travel agency using the turnover method would have yielded grossly inaccurate results because the industry multiple did not reflect the current market conditions for the travel industry at the time.

While this type of valuation is excellent for a very fast rough estimate, AVGI strongly recommends not relying on turnover-based valuations to make key financial decisions. The adjusted revenue multiple method can be a better alternative for quick results, as it considers the business’s profit margins and growth potential, providing a more accurate estimate of its value. However, the fact remains that quick and dirty valuations will yield quick and dirty results.

Business Valuation Approaches & Methods

There are three main approaches to calculating business value:

1. Income Approach

2. Market Approach

3. Asset Approach

Each of these approaches encompasses several specific calculation methods. A qualified business appraiser will generally select the most relevant approach and method based on the business’s financial and market profile, available information, and the valuation purpose. At AVGI, we often use all applicable approaches and methods to value a business from multiple angles. We then weight the results appropriately to reach the most accurate measure of business value. This much more thorough approach takes into account all aspects of the business, both internal and external factors, and yields a valuation that accurately reflects the business’s market value. You can read more in-depth about how AVGI values businesses here.

Why a Professional Business Appraisal is Crucial

Particularly when stakes are high, such as during a business transaction, litigation, or valuation for tax purposes, AVGI highly recommends getting a professional appraisal rather than relying on estimates. There are numerous implications of using inaccurate valuation, usually to the detriment of the owner, including overpaying taxes, losing litigation, or vastly underpricing their business for sale.

Conclusion

Business valuation is a critical aspect of the business acquisition process, and it is essential to understand the different methods and factors that affect business value. Determining the business value based on turnover can be useful for conducting preliminary company research for investing purposes or for the company to perform an internal review. However, for more complex and higher stake purposes, business owners should consult a professional valuator to determine the accurate value of their business.

AVGI brings over 30 years of business valuation expertise to every valuation. Contact us today for a free consultation.