Understanding the value of a dealership has long been the subject of debate, with many focusing on earnings multipliers as a key valuation method. But with the economic tumult brought by the COVID-19 pandemic, the importance of a sustainable earnings base in dealership acquisitions and dispositions has come into sharp focus.
A New Way of Understanding the Value of a Dealership
Let’s explore this concept using the case of a Toyota dealership with an earnings multiplier of 6-7 times. But before delving into specifics, it’s worth understanding the basics.
Traditionally, many acquisitions and dispositions employed a multiple-of-earnings approach, which takes a company's net earnings and multiplies it by a factor ranging between 6 and 7 times. The Toyota dealership mentioned above uses this method to estimate a company’s worth.
But the global pandemic challenged this approach.
Let's illustrate it: The pre-COVID earnings of the Toyota dealership were $4M, which would yield a valuation between $24M and $28M using a 6-7 times multiplier. When the pandemic hit, supply chain disruptions, price increases, and a high demand for personal vehicles boosted earnings to $8.5M, implying a valuation between $51M and $59.5M using the same multiplier.
This surge might seem attractive to potential investors or acquirers. However, it’s crucial to recognize that these inflated earnings were largely a product of an extraordinary situation — not a sustainable business model.
In contrast, the sustainable earnings base approach evaluates the dealership’s expected earnings over the long term, incorporating its potential to generate steady profits in varying market conditions. It assesses a dealership’s historical performance, market position, industry trends, and more to determine a realistic, sustainable earnings figure.
Using this method, the Toyota dealership has sustainable earnings of $6.5M, providing a more reliable valuation between $39M and $45.5M.
Sustainable Earnings Base vs. Multiple-of-Earnings
The sustainable earnings base offers several key advantages over the multiple-of-earnings approach:
- Stability over volatility: With earnings fluctuating due to many factors, using a multiplier on the previous years’ earnings can yield misleading results. The sustainable earnings base, on the other hand, evens out short-term disruptions to provide a more stable and realistic valuation.
- Future-proof valuation: While the multiple-of-earnings approach focuses on past performance, the sustainable earnings base offers a forward-looking view that better captures the dealership’s potential and mitigates the risk of over- or underestimating its value.
- Resilience in uncertainty: The COVID-19 pandemic demonstrated the unpredictability of market conditions. Sustainable earnings incorporate a dealership's ability to navigate and adapt to change, offering a more resilient valuation that withstands the test of time.
Let’s return to our Toyota dealership example. If an investor were to acquire the dealership based on COVID earnings of $8.5M, they'd potentially overpay, as these inflated earnings are not representative of normal operating conditions.
Basing the acquisition on sustainable earnings of $6.5M would lead to a more accurate purchase price, avoiding overpayment and aligning the investment with long-term expectations.
Wrapping Up
While the multiple-of-earnings approach has traditionally been a popular valuation method, the importance of a sustainable earnings base in dealership acquisitions and dispositions has become increasingly evident.
Sustainable earnings offer a more reliable and future-proof valuation by smoothing out short-term fluctuations and focusing on long-term stability and resilience. They provide a solid foundation for informed decision-making and successful investment in an ever-evolving marketplace.
At Ozog Consulting Group, we take a "return on investment" (ROI) approach to dealership valuations. This method ensures that our sellers find qualified buyers, our buyers aren’t overpaying, and both groups’ needs are met.
Want to learn more about this game-changer? Contact the Ozog team.