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The End Result

Andrew Morgan - Wednesday, September 26, 2018

Written by Andrew Morgan, Specialist Resort & Motel Broker

Every now and again I hear the comment that “the Income is not high enough” when a prospective investor is looking at a business.  When I say Income, some call it Turnover, some call it Sales Revenue, and the list goes on.  The only reason I can conclude in regard to the objection, is that the potential buyer looking to buy the business is planning on operating it at a lower profit margin or higher cost base.  Usually new operators look to reduce overheads and improve profit margins to increase the Net Profit and therefore the value of the business.  The value of any business is largely determined by two factors, the return on investment, capitalisation rate, or yield and the Net Profit of the business, against this yield.
Depending on the structure of the business, how it produces its income, how it operates and the resultant profit margin it achieves, will determine what income the business makes and what profit it can achieve.  A business producing a high profit margin will have low overheads and therefore a high profit in relation to sales income.  Vice versa for a low profit margin with high operating costs to produce its income.  Every business will produce a different profit margin.

The Net Operating Profit of any type of business is the determining factor for assessing the business’ value.  No valuer determines a business valuation on the basis of what Sales Income is produced.  Yes, it plays its role in the process, however capitalising an income figure as opposed to a Net Profit is not done.

The value of cashflow to a business, relates directly to the day to day operation of the business, not the on-going Net Operating Profit over the period of say a year.  It stands to reason though that a motel with a higher Sales Revenue that also has higher Operating Expenses, may therefore have the same cashflow problems that a motel with lower sales and lower expenses has.

A simple comparison to consider.
 
Motel A 
  25 units & Restaurant  
Motel B
  25 units & Restaurant  
Annual Sales Revenue   $1,000,000  $750,000
 Annual Net Operating Profit  $400,000  $400,000
 Net Profit Margin  40%  53%
 Return on Investment  14%  14%
 Freehold Value in the Market  $2,850,000  $2,850,000

Now with both these motels being valued at the same price in the market due to their returns on investment being the same, why would a lower Sales Revenue make Motel B worth less than Motel A?  These motels have very different Sales Revenues, however their Net Operating Profit is the same.  The reasons for this are numerous, however a few explanations may be that one is operated more efficiently than the other, or because one has a source of revenue that is not as profitable as others, or because the particular location attracts higher operating costs, etc.  A big one is often the underselling of a unit.  A 90% occupancy rate on a tariff 20% less than what is achievable will do it!  In other words, discounting!  The easiest way to create a higher cost base and operate less efficiently.


Either way, the business with the lower Sales Revenue is not worth less than the one with the higher Sales Revenue? I would assume that the business with the lower Sales Revenue and Higher Profitability could end up being more attractive to the market than the Motel with the higher Sales Revenue.  This would be due to it being potentially less labour intensive or having a lower level of risk than the other, by being able to operate at a lower cost base.

As mentioned, a Registered Valuer who is doing a Valuation on a Motel Property or Business will base their valuation on a Capitalisation Rate of the Net Operating Profit of the business, not the Sales Revenue.  Therefore in the above example, with all else being equal, Motel A and Motel B will be valued at approximately the same level, even though they have substantially different Sales Revenues.