The second most weighted factor in the risk multiplier series for the Discretionary Income Multiplier Formula is business and industry growth. This factor evaluates the overall change in an industry and in particular the business under review over the most recent three years. As a small business owner, you need to understand the importance and the value the business and industry growth factor bears on the final multiplying factor.
In evaluating a business’s worth, ten risk factors are graded between zero and three. Each of the ten risk factors has a weighted value in the overall risk factor number. The risk factor number ends up between zero and three. Each of the ten factors has different weights assigned. Business and growth is the second most important factor in the group of ten. Its overall weighted value is 16.36% of the final value. So when a small business owner is evaluating his own or the value of another business, this particular category carries significant importance in the overall final determined value.
So how do you determine this respective factor’s value?
The key to getting this number is focused on two steps. First, set the industry’s growth within one of three tiers. Next, evaluate where the business performs within this respective tier. There are three tiers to the business and industry growth factor. Below explains each tier and the value range assigned to that respective tier:
Lowest Tier – Value range .01 -.99
In general, this range refers to a dying industry. All industries have a life expectancy associated with them. Many start out as a fledgling misunderstood industry and then grow quickly and then suddenly have a lot of participants in their industry. The whole industry reaches a saturation point and will then begin to slowly tail off or begin to die. As the industry passes maturity, death is more eminent than some type of rebirth. Below are examples of industries in the modern era that are closer to dying than to maintaining their current market share or dollar value.
- Tubular Television – (Cathode Ray Tube) pretty much was killed off by the FCC changes that occurred a few years back. Nobody produces them, however, back in the 60’s, color TV’s were the rage.
- Land Line Phones – I’m not sure, but I don’t think you can buy them anymore; however, they are still common in the office environment. For the typical homeowner, the cell phone has pretty much eliminated their existence.
- Home Heating Oil – more and more homes are converting to some other form of energy to heat the house. There are several driving forces; first, most new communities install natural gas because of the cost associated with installation. The natural gas industry subsidized new community gas lines in order to have it available to the new homes, thereby buyers elected the natural gas system over heating oil. Secondly heating oil is dirty, releases unpleasant fumes, and finally oil requires a large cash outlay each time the oil guy fills your tank. Due to chaotic oil prices, there is a lack of confidence in the product’s price stability. All of these factors drive customers to a different fuel to heat their home.
In addition to the industry, you have to look at the business too. Is the business able to maintain its customer base even though the industry is dying? Think of the home heating oil industry in the example above. Although the industry is slowly dying, does the business that provides the oil maintain its customers? Often, older neighborhoods can’t make the transition to the new product and continue to use the old system. If the business is able to maintain its portfolio, than you may want to consider elevating the business to the second tier.
Mid-Range – Value range 1.00 to 1.99
Most industries are in a stagnant period of no growth but mostly maintenance and minor modifications to the overall need. Here the small business owner should address the time expectancy for this plateaued period. Unless a new industry is created that will overwhelm the existing industry, it is unlikely this industry is headed towards death or minimal existence. The best way to evaluate this is to use some examples:
- Coal – some will argue this is even a growth industry with the demand from foreign nations for the coal resources available in the US. However, due to the restrictions related to clean burning and the government regulations, it is unlikely this industry will grow, but is closer to maintaining its market share than towards a decline. Since competition is only starting with clean fuels and the costs associated with conversion of existing coal burning plants, this industry will see many years of continuous market for the product.
- Cell phones – although smart phones have garnered the majority of the market, it does not appear at this time that communications will have some type of new tool to use. I don’t see mental telepathy coming around anytime soon. So for the foreseen future, cell phones will have little to no growth. You have to be realistic about this; pretty much everyone has a cell phone right now.
- Paper Printers – this industry is closer to the dying tier than to the next tier of growth. More and more of the public are beginning to use computer technology to transfer information. Up until about 2005, paper was the pretty much the best tool to convey one’s thoughts to the customer/client. Now, more and more technology and the depth of utilization is allowing for the average consumer to rely on the image on the screen as the equivalent of paper.
With the example of the home heating oil business from above, if the existing business is able to hold onto and not lose customers over an extended period of time, then this is the tier range to determine the final risk factor value. If you were evaluating the business, if the operation were able to absorb an existing smaller business and its customers due to the changing dynamics of the industry and territory, you could consider a number higher in this range, maybe a 1.7 or 1.8 depending on the circumstances of that purchase. So when evaluating the business within this tier use some history, the industry issues and the overall customer base in determining the final number.
Upper Tier – Value range of 2.00 – 2.99
This range is for those industries or businesses in a growth stage. Several industries are in a growth spurt. However, growth spurts are similar to what happens in children, some make significant changes, others, the change is barely measurable. If the industry has clearly demonstrated significant changes than the final number would be above 2.5. My personal feeling is that no industry has the opportunity to be in the 2.7 to 2.99 range unless it’s pretty much unheard of or to capital intensive for the average person. Examples of high growth (above 2.7) industries right now would include bio-medicine (your average person has no clue about this because of the science involved); electrical energy packs (electrical energy fuel cell technology), and electric automobiles (very capital intensive to get involved).
For the oil business company identified above, it is unlikely any growth opportunities exist. Therefore, for this business an appraiser should not consider a number above 2.3 no matter how well this particular business is performing. The possibility of high growth or any growth is remote at best.
When evaluating the business itself, use the tier as your guide. Within that industry’s tier, look for the positive aspects to rank it in the upper half of the tier. If more negatives than positives, than the lower half of that tier is appropriate. You may possibly shift the business out of the industry’s tier to the next level contingent on some outstanding performance factor or reason to substantiate the elevated change. Just as there may be a reason to elevate the shift to the higher level, there are more likely reasons to justify reducing the level to the lower tier. Again, think of the oil business I used in my examples above. Odds are that there are more issues going against the business than there are positives attributes warranting an increase in the tier level or even justification to stay within the tier level itself.
By using the overall life cycle of the industry and the performance of the business, a small business owner can determine the best value to assign the company for the purpose of the business and industry growth risk factor. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my help as an accountant or consultant, contact me through the ‘My Services’ page in the footer.