As we have discussed before, understanding the value of a business is important at every stage of its life.
By tracking value over time, we can see its trajectory. By understanding the factors that impact value, we can better identify where to focus our time, energy and investment.
In the grocery industry, there are multiple valuation methodologies in use, but the primary model remains EBITDA, or earnings before interest, taxes, depreciation and amortization. That number is then subject to a multiplier to arrive at enterprise value.
The most obvious influences on EBITDA are sales and expenses. Sales – and techniques to increase them – are a topic unto themselves and one our industry discusses every day (and which will be a subject of the next article in this series).
Expenses, on the other hand, include both obvious and less obvious factors that can meaningfully influence value.
One of those factors is rent.
If you do not own your real estate, keeping rent to a minimum is an objective. But what if you do own it? How should you think about rent or mortgage costs?
First, if you own the real estate, you understand that higher rent received as the landlord generally increases the value of the real estate.
Commercial real estate is typically valued using a capitalization rate, where net operating income is the numerator and the cap rate is the denominator. We will explore this in more detail in a future article.
For now, it is enough to understand that if you own both the operations and the real estate, the values tend to be self-correcting. Showing a lower lease payment increases EBITDA and, therefore, the value of the operating business.
At the same time, it lowers net operating income on the real estate side, reducing the value of the property. Increasing rent does the opposite.
As long as you are on both sides of the transaction, the decision to increase or decrease rent primarily affects where value shows up – on the operations or the real estate – rather than the total enterprise value.
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There are, of course, many reasons to favor one over the other, including tax considerations and differing ownership percentages. But when you own the real estate, it is critical to look at the combined value of both assets in evaluating the business.
Also, as a rule, many in the grocery industry would suggest that triple net lease payments should be at or below 2 percent of monthly sales.
The physical condition of the store also has a substantial impact on value. Capital expenditures and ongoing maintenance affect the customer experience and, ultimately, financial performance.
Failure to keep a store updated and well-maintained means that a future buyer will need to invest significant capital to make it competitive. Over time, deferred maintenance also impacts sales, as customers’ perception of quality and value erodes.
Another factor impacting value – though it may be less obvious – is any restriction on the ability to make changes in the operation.
Long-term supply agreements with wholesalers, distributors or vendors are not inherently bad. In fact, they can bring stability, opportunity and scale.
However, from a valuation perspective, imagine being a new buyer with ideas for change, only to discover you are contractually prevented from implementing them.
While such agreements may make sense operationally, they can reduce the valuation multiplier if they are binding on a successor owner. Awareness of this trade-off is essential.
Finally, market dynamics play a critical role in valuation. A market analysis showing a vibrant, growing community that is likely to continue supporting a store clearly enhances value.
Conversely, a negative or absent market analysis raises questions about long-term viability. This should be a significant factor when deciding where to invest capital and attention, and it will certainly matter to any potential buyer.
The bottom line: by creating a realistic valuation and applying consistent methodologies on an annual basis, we can see the direction a business is headed. That clarity will influence better decisions – and help to build a business designed to last.
Carey Berger is president of Business Service Resource Group.