In last month’s article, we discussed the differences between formal and informal business valuations. This month, we’ll discuss valuation methodologies and some of the ways in which you may gain insight into the value of your own business.
Formal valuations are generally based upon three valuation methodologies: asset approach, income approach, and comparative approach.
ASSET APPROACHES
There are three types of valuation methods using asset approaches: Book Value, Adjusted Book Value and Liquidation Value.
Book Value (“BV”) is the equity value of your company as indicated on your balance sheet. BV is a “pure number” in that it is unadjusted.
Adjusted Book Value (“ABV”) involves adjusting your balance sheet to account for the current market value of certain assets or liabilities as well as adjusting for non-operational assets or liabilities. For example, assume you took advantage of all the “bonus” Section 179 depreciation options available to business owners over the past three years, resulting in $800,000 of purchased long-term assets fully depreciated immediately. While these operating assets carry zero value on your balance sheet, certainly they are worth more than zero. Similarly, if you purchased an airplane for your business using a long-term loan, but the plane is only used infrequently, removing the asset and liability make sense for determining adjusted book value. The purpose of ABV is to give you a better idea of the more reasonable or “true” equity value of your business.
Liquidation Value (“LV”) is most often used by lenders to determine the value of your assets and liabilities if the company were to be liquidated. There are generally two types of liquidation valuations: Orderly Liquidation Value (“OLV”) and Forced Liquidation Value (“FLV”). OLV assumes the owner of the assets will have “time” to liquidate the assets in an orderly fashion. FLV assumes a “going out of business” auction price. OLVs are always higher in value than FLVs.
Generally speaking, ABV is higher than BV and both are higher than OLV, which is always higher than FLV.
Unlike BV, both ABV and LV require you (or the valuation expert) to make certain assumptions about the value of your assets and liabilities. Of course, assumptions are always subject to scrutiny and validation.
INCOME APPROACHES
For most businesses, there are two salient valuation methods using income approaches: Capitalization of Earnings (“CoE”) and Discounted Future Earnings (“DFE”). In simple terms, CoE is a backward looking approach (utilizing current or average earnings) while DFE is a forward looking approach (utilizing projected earnings) to valuations.
While determining the value of your business using CoE is no simple matter and requires a fair amount of research and several critical assumptions, we can describe the formula succinctly: divide your company’s earnings by a capitalization rate, adjust for non-operating assets or liabilities, and, like magic, you have the value of your business.
Cap Rates are always expressed as a percentage, which means the lower the rate, the more stable the business and its earnings. Alternatively stated, the higher the cap rate, the more risky the business. Furthermore, since all businesses are unique, the determination of cap rates is different and unique for each business. It would be a huge mistake for you to use the cap rate determined for another business to value your own company.
However, determining the proper cap rate and choosing the correct earnings to capitalize are never so easy or straightforward. But rather than bore you with a long explanation involving calculus and some fairly complex calculations and research, suffice it to say, cap rate determination is no easy subject, nor is it something you can do without significant training.
DFE, while a very well-known calculation, is no easier to determine than CoE and also involves significant research and the use of the Cap Rate you determined for your business. DFE is used to determine the present value of your business by calculating the value of the future income stream of your business discounted by the Cap Rate to a current value (similar to calculating time-value of money except the Cap Rate is used instead of a discount rate). As with Cap Rate calculations, DFE involves numerous assumptions: the growth rate of your company’s earnings, its Cap Rate, and the “terminal value” of the business in the future.
While DFE is difficult to calculate, this is a valuation method incorporated by most sophisticated acquirers since it helps provide them with an expected return on their investment (“ROI”). Buyers would most likely use a “standardized” Cap Rate for these estimations. Thus, of all the approaches we’ll discuss, DFE is the one you should try to get most comfortable with if you are serious about valuing your business for sale.
COMPARISON APPROACHES
As the name implies, Comparison Approaches in valuations compare your business with similar companies; that is, companies in the same industry of approximately the same size (sales and earnings). There are two types of comparison approaches: Private Company Comps and Public Company Comps.
Private Company Comps utilize the data from completed transactions to help determine the value of your business. The two most popular approaches are Price to Sales ratio and Price to Earnings ratio. In the Price to Sales method, you find as many companies similar to yours that have been sold, determine the sale price relative to the sold company’s annual sales, and then average these to determine the ratio for your company. You can do the same calculation of a Price to Earnings ratio.
There are two inherent challenges with Private Company Comp methods:
- Data on private company sales is not always easy to find. Unlike MLS data for home sales, private company sales are just that…private. There are databases of private company transactions, but there isn’t always data relevant to all types of businesses. The more specialized your company, the less likely there will be data from sales of similar businesses.
- Not all information is created equally. Back in the Dot-Com boom, we saw interesting done-deal data showing fantastic multiples for some transactions. When we dug deeper and called the companies involved in the transactions, we learned these companies had sold for 5% cash at closing and 95% stock in the private company who acquired them. A deal involving a huge amount of seller financing should sell for more than a deal with 100% cash at close. However, many done-deal databases do not take into account transaction structure…or those doing the valuation using these comps do not take this critical information into account in their analysis.
Public Company Comps require you to compare your business to companies similar to yours whose stock is publicly traded. The classic Public Comps are Price to Sales and Price to Earnings. Just as with Private Comps, there are several challenges to using Public Comps to value your company:
- Public companies are public and your company is not. There is a cost to being public. Presently, we estimate this cost at between $1 million and $2 million, annually (these costs include expenses related to compliance with Sarbanes-Oxley and other similar regulations, regulatory compliance costs, annual financial audits, annual shareholder reports and meetings, and more). Thus, if your company does not have at least $2 million in AFTER TAX EARNINGS, public comps really are not germane.
- As shown in bold above, public companies report their earnings based on after tax profits. Most business owners of privately held companies run their businesses with the idea of showing a minimum of taxable income.
- Size does matter. Most public companies are significantly larger than similar private companies in the same industry. Does it make sense to compare your wholesale cartridge distribution company with $50 million in sales and $4 million in pre-tax profit with Hewlett Packard who has $22 billion in sales and $3 billion in after tax profit in its printer/supplies division?
End of the day, these formal valuation methods are helpful in determining the value of your business, but if you are considering a sale of your company, its ultimate value will be determined by the price a buyer is willing to pay. So how do buyers of your business determine value, especially when acquiring companies in the imaging industry?
As previously mentioned, many buyers utilize DFE as a key metric. Another factor is the amount of leverage (or borrowing ability) available to a buyer for your business. Buyers use these methods, along with comparison of deal multiples, to value the businesses they seed to acquire, but they also adjust their valuations based on the following value enhancers and value detractors.
VALUE ENHANCERS/DETRACTORS
What are the factors impacting the value of your company, both positively and negatively?
- Is yours an asset “heavy” or “light” business? Equipment dealers generally have more in the way of “leverageable” assets which may be of more value to some buyers who look to use as much leverage as possible. However, cash flow buyers prefer asset-light businesses like supply wholesalers and on-line distributors.
- Stability/sustainability of your revenues and earnings. Has your business been growing? Is your growth due to an increase in customers or simply price increases? What is the likelihood of continuing with your current growth rate?
- Transferability/stickiness of your customer contracts. If you are an equipment dealer who earns a significant portion of your revenue/earnings from on-going service/maintenance agreements, are those agreements transferable…without customer approval? If not, that is a value detractor. What is your attrition rate on these contracts/customers? If it is higher than industry average, that’s another value detractor.
- Approval process for transfer of dealerships. Are you an equipment dealer/distributor? If so, have you reviewed your dealer agreement regarding change of control and/or a sale of the business? Almost all equipment OEMs must approve the transfer of your dealership. The transfer clauses in dealer agreements vary by OEM and can have a significant impact on value. We lost a deal several years ago because the OEM would not approve our client’s chosen buyer because the buyer, in the OEM’s opinion, sold competing products.
- Territorial/Product restrictions impact value. Several years ago, we were selling a client’s multi-location imaging equipment dealership. Our client’s dealer agreement restricted them to a certain trade area. One buyer who made a very strong offer backed out of the process when the buyer learned about the territorial restrictions, stating this would hamper the buyer’s ultimate growth plans.
- Management depth. Buyers always ask, “If something happens to the owner, is the business sustainable?” If the business revolves around you, and you are no longer in the business, there isn’t much value to your company.
- Can you show a positive bottom-line without significant adjustments? In other words, are you using tax deferral methods, such as running personal or non-operating expenses through the business, so as to reduce your taxable income? If so, this can impact value significantly. Buyers tend to “value what they can see.” Two years ago, we were working with an imaging supply wholesaler. Our client was profitable, but only when we made significant adjustments to earnings. All of the buyers we spoke to were interested but ultimately backed out of the process stating, “It is just too hard for us to see where the profits are in the business; validating all of these adjustments requires just too much work for us.”
- Do you have good, clean financial and operational data? Can you provide buyers with sales by customer by year data? Can you tell buyers your gross margin by product or product line for any given month? The better your data, the more you can slice & dice the numbers, the more a buyer may be willing to pay for your business.
As you can see, there are myriad factors influencing and impacting the value of your business. While there is no single “magic bullet” for determining the value of your company, the methods outlined above should help you get a better idea of what your company might be worth on the market today.
Next month, we’ll discuss a valuation subject near and dear to everyone’s heart: purchase price multiples and how to use them for your business.
