InSight

Exit and Growth Strategies for Middle Market Businesses

Business Valuation: Continued!

By Lee Crawley | Sep 30, 2009

Another look at “Valuation: Getting the Right Price When Selling Your Business”, an article by Gary Parker.

I think Gary has done an excellent job of summarizing the valuation process. However, I feel that he and many others that have written about “valuing” your company have made the explanation too complicated or mysterious.

This writing is an attempt to simplify the explanation of this process and to provide a conclusion that hopefully gives potential clients more comfort that professional “intermediaries” like CFA can provide very reasonable estimates of what their company will be worth.

I am “certified” by NACVA (National Association of Certified Valuation Analysts), which required a great deal of study, testing and experience and as such, I feel I have learned to navigate the valuation “maze” more effectively.

The first and in many respects the most important question of a valuation is “what is its ‘purpose?’” While there can be many reasons for a valuation, the purpose for our clients is the sale of their company (all or part) and as such we will be using the Fair Market Value Approach. This is defined to mean “willing buyer, willing seller both acting with the same information and no compulsion to act”. While academic it is very practical when combined with the market experience of professionals like CFA that have seen hundreds of transactions during their careers. I will only say that other “purposes” such as estate planning will use different approaches, which lead to different methods mentioned in Gary’s article.

The second important point is the clarification that “valuing” companies for sale involves demonstrating that the company is a “going concern” and has a value greater than the “liquidation” value of its assets which as Gary pointed out is generally accounted for as “goodwill”. This eliminates the Cost Method and the Adjusted Book Method which is simply my recommended method in disguise.

The last important point is that a “certified” valuation is based on a debt free basis and that the payment to the seller is all cash at closing, which of course rarely happens.

With these clarifications (or are they complications?) I will now provide my explanation on how to estimate “value” in the real world.

The value of a company is the value of its “future” profitability to a willing buyer. Now there is the real rub! What is the “future” profitability going to be? That could be another Blog topic.

For now, let’s assume that future profitability will reflect a reasonable correlation with the historical results.  Two notes at this point: One, most Business Owners strive to minimize taxes and as such the “profits” will have to be “restated” to reflect profits if certain expenses had not been incurred. Two, the term “profits” is more fundamentally meant to be “cash flow” (another blog topic).

Let’s assume that sales and “profits” have been up and down over the past five years but generally they are moving in a positive direction. By developing a “trend” line of the past we can project the “future” sales and profits. The value of the company (debt free) will be determined by discounting future “profits” to determine their “present” value. While determining an appropriate discount rate is not precise, a company’s “cost of capital” (discount rate) falls within a fairly narrow range. One additional factor that influences the discounting is the companies “growth” rate of its profits.

As an example, most companies that CFA deals with in the lower middle market ($5 to $50 mm valuations) will have a “cost of capital” between 20 to 25% depending on its size and the nature of its business. This discount rate will be lowered by the company’s growth rate (if positive). Let’s assume the growth rate is 5% and that its cost of capital was 25%, then its discount rate would be 20%.

My conclusion is therefore, that I am comfortable stating that a skilled intermediary such as those at CFA should be able to use your historical financials (past 5 years) and a brief interview with you about your company and its industry to give you a very reasonable estimate in a narrow range. This will take some time but should involve less than 10 hours. As an example let’s assume that a company’s profit (cash flow) was expected to grow at 5% rate from $3 million in 2008. With a cost of capital of 25%, a 20% discount rate would produce a reasonable estimate of $15 million (i.e. a 5 multiple). Typically, I use a plus or minus 10%, yielding a range of $13.5 to $16.5 million.

One of the important services that intermediaries like CFA provides is the creation of a competitive process whereby several “very interested” buyers drive the price to the high side of the range. Lack of competition tends to move the price to the lower side of the range which typically happens when sellers negotiate with a single buyer.

All of the other methods mentioned in Gary’s article are interesting but somewhat academic. The “Market Approach” is very limited in its real world applications, although heavily used for practitioners who do not have the experience of many CFA professionals. All transactions that do not involve a public company are not made public. 98% of CFA’s transactions are in the private domain and are confidential. Most private company “databases” are suspect for several reasons. First, they do not adhere to the all cash at closing requirement because of earn-outs or seller financing. This typically overstates “multiples”. Because the information on private transactions is confidential and unverifiable, this typically leads to overstatement. While I do think transaction databases are useful by “skilled’ intermediaries, I think the DCF Method is the most reliable.

The single period Capitalization Method is nothing but a simplification of the Multiple Period Discounting Method if you understand the math.

In closing, I want to use today’s economic environment to explain how the DCF Method makes “common sense”. Most companies “profitability” are down and the cost of capital for most companies is up because of perceived higher risk. This yields a lower valuation than would have existed in late 2007 and early 2008.

Don’t let intermediaries leave you in the dark on your company’s value. While you may not like the answer; hopefully, you will respect the competence of the messenger.

posted by Lee Crawley


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