The Justification of Purchase (JOP) Test is a way of assessing the reasonability of a value conclusion. A value is justified if the entire business (100% of the equity), purchased at the indicated value, can:
Pay the owner / manager fair market compensation
Adequately service assumed and acquisition-related debt
Earn a satisfactory return on equity
Some businesses can meet only the first two criteria, but not the third. These are colloquially termed “buy-a-job businesses”. This is because they provide their owner / managers jobs but not much else, if anything, above that in terms of the benefits of ownership. They have to be viable – pay the owner manager a living wage and be able to keep the bank happy – so that they can survive long-term. In my experience, many single-location retail establishments and sole practitioner professional practices (including, unfortunately, mine) are buy-a-job businesses. Buy-a-job businesses, at appraisal, often have Market Approach (and possibly Asset Approach) values well in excess of the Income Approach. That, to me, is a big clue to help identify them.
There is nothing inherently wrong or bad with buy-a-job businesses. It is just that they do not offer prospects of good returns on equity. Hey, I earn a nice living from my appraisal practice, and I pay all the bills, including the mortgage, timely! I just do not expect a large pot of gold when I reach the end of my rainbow of (useful) life. This is because the goodwill that I have built up (however small that might be) is personal, and probably cannot easily be transferred to someone else.
Some businesses are buy-a-job because of the nature of the industry; there is just not enough growth or profit potential in them to generate significant cash flow to equity. Others, like auto dealerships presently, are economically depressed (and might recover to earn returns on equity). Some are set up that way. Many professional service firms are really just shared-overhead arrangements between partners, who earn what they bill net of direct and overhead expenses. There are also many family-owned businesses that have a primary objective of employing (many) family members, which reduces or eliminates return on equity.
The last point really hit home for me recently. I valued several family owned businesses that are essentially buy-a-job businesses because, although they are large (one of them had over $8 million in revenue), firmly established, and financially secure, none of them earns significant returns on equity (measured by cash flow to equity divided by the business value). I had always reflexively envisioned buy-a-job businesses to be small ones; I now realize that that is not necessarily true. I guess this is a case where “size does NOT matter!”