Thinking of buying a second pharmacy? You might want to read this first.

This should have been the happiest of times. Would-be pharmacy owner John was the winner of a bid for a new pharmacy, and he was excited to settle in and get working.

The tendering process had been tense, but John was confident he had paid the right price after consulting with other owners and colleagues, and he believed his “multiple of earnings” balanced both the chances of winning and affordability.

But John overpaid, and upcoming regulatory changes could cause him to struggle servicing his debt load. This potentially devastating acquisition error can be traced back to his research and over-exuberance. Despite good intentions, he overestimated the market price, and his data were unreliable. Also, blinded by the prospect of ownership, he did not reflect on the value of the business, only its price. In other words, John paid what he thought he had to, not what he should have.

In the stock market, investors refer to an “efficient market” concept, which suggests that it is impossible to “beat the market” since all participants have access to all relevant information with which to determine price. In retail acquisitions, there is no such efficiency; there are no databases, websites or tables to use as a reference to gain the relevant information. Market price, therefore, is quite difficult to predict, but acquirers have a much greater challenge: gaining enough knowledge to determine the inherent value. So, unlike the markets where the stock price incorporates the intrinsic value, the market price of a convenience retail operation – as hard as it is to determine – can vary widely from its value.

Determining market price

Assuming the financial statements were normalized correctly and reconciled to the retail reports, there was still a lack of reliable data with which to derive the market price. You may not need “n = 30” data points, but you will still need a substantial number for significance. Furthermore, your aggregate data must be on similar c-retail types. The multiple of earnings derived from a collection of pharmacies from different regions, with different formats, is unreliable. Always consider who has provided the information as well and ensure that exaggeration has not entered the equation.

Determining the value

The value of the pharmacy requires careful analysis and extends well beyond an accurate normalization. Deriving the real value of a convenience retail operation requires two additional but critical elements: an accurately forecasted income stream and the quantification of risk. Utilizing a capitalization of earnings formula (where value equals the income stream divided by the risk rate), higher risk equates to a lower value. Keep in mind that with less projected income stream confidence comes higher risk. Quantifying risk is not straightforward, but it can be accomplished through a thorough and careful examination of factors that would cause material harm to the business.

To successfully acquire a pharmacy, you need to collect adequate information from reputable sources, understand the regulatory environment and sources of revenue, utilize trusted professionals, and be wary of irrational enthusiasm.