Welcome Bruce Heinemann
Welcome to the Team!
Bruce Heinemann is a roll-up your sleeves, strategic and results-oriented driven CFO. He creates positive financial outcomes while simultaneously supporting Private Equity, C-Suite, Supply Chain, and Field Operations. Bruce has over 30 years of history, building shareholder value in middle markets ($150M – $400M). He has a unique background as 25+ years in progressively broader Financial responsibility, as well as 10+ years in a leadership role with complex, multi-national supply chains in the electronic and industrial markets.
Practical Issues in Valuation
As a knowledgeable buyer or a valuation expert begins to apply their toolkit to establish a value of a company, three questions must be answered:
• How much will the cash flows for this company be in the future?
• What are the uncertainties that could make these not come to fruition?
• How would a new owner view these cash flows and uncertainties?
Will the real Cash Flow please standup?
To calculate “cash flow” (meaning whatever metric of cash flow is being used at the time) several issues specific to the company will come to bear. Often a major factor is the nature of the fixed assets of the company and the relationship of capital expenditures (a real use of cash) to depreciation (a non-cash expense). Service businesses will often have expenditures that are similar in nature even if the accounting terminology is different. A company with substantial fixed assets will often have a higher EBITDA (earnings before interest, taxes and depreciation) than a company with comparable earning power but fewer fixed assets. These companies may have a different multiple used to determine value, suggesting differing or more or less attractive “valuations”. In fact, the two companies may have the same value. As an example, consider AssetMax which has $5 million of EBITDA, including $2 million of annual depreciation, and $1 million of annual sustaining capital expenditures (CAPEX). AssetMax may have a value calculated at 5 times EBITDA, or $25 million. AssetLite generates $4.5 M of EBITDA with only $500,000 of depreciation and the same amount of CAPEX. Since it is less capital intensive, it may be valued at a higher multiple than AssetMax. At a multiple of about 5.6 times EBITDA. AssetLite would also have a value of $25 million. Determining which company has a “better” valuation is left to the reader. This example illustrates the concept of free cash flow, which can be defined as EBITDA minus capital expenditures and any increase in working capital associated with company growth. Thus, similar valuation issues develop from the asset intensity of the working capital elements of the balance sheet as arise with CAPEX. Companies maintaining high inventories will be valued differently than those that do not. The same concept holds true for accounts receivable. In general, higher asset intensity will yield lower free cash flows, cash earnings and lower valuation multiples. The development of a valuation multiple requires careful comparison to truly comparable situations.
Another key factor in arriving at the multiple is the future growth rate of the company. Presuming that increasing sales yield additional earnings, an assumption of future growth will always yield a higher value. It is no wonder that it is a rare Offering Memorandum that does not show solid double digit or better growth!
More Thoughts on Uncertainty
Track record, strategic position of the company, and human resources are the key internal elements that determine the magnitude of the uncertainty factors in a valuation. A long, stable track record of consistent or growing earnings or cash flow is a critical factor in reducing uncertainty and will result in a lower uncertainty discount. Conversely, the lack of such a history leads to a higher discount factor. Although sellers would like to think that a company should be valued based solely on its just completed record year, this is generally not how a buyer will perceive its value. In the world of distressed investing, a company may be suffering from negative cash flows but still have a positive value. This derives from the value of the underlying assets and the expectation of future cash flows. The uncertainties of the future cash flows are usually very high which causes a buyer to heavily discount the values paid for distressed transactions.
There are several strategic factors related to the industry that a company is in and that company’s position within the industry that influence the uncertainty surrounding future cash flows. These include:
• Competitive intensity of the company’s industry
• Unique competitive advantages the company enjoys
• Growth in the company’s industry
• Industry dynamics (cyclicality, seasonality)
• Industry structure (customer concentration, pricing power)
To see how these factors impact uncertainty, consider the following situations. A supplier of a patented critical ingredient that is designed into an FDA approved product, with a 10 year design cycle, has a much greater level of certainty relative to a contract manufacturer of stamped parts for the automotive supply chain.
A greatly overlooked factor, especially in the lower mid-market, is the element of management and human resources in general. Uncertainty increases when the company’s competitive advantage walks out the door every evening, or the critical knowledge and expertise of the company is concentrated in a few key employees or, even worse, the selling owner who is headed to retirement in the Sunbelt. Businesses with deeper management who are willing to stay on in the event of a sale or an owner who will commit to a post-closing transition period will greatly reduce a buyer’s uncertainty related to management continuity. A company with a unionized workforce can result in increased uncertainty and may result in a lower valuation multiple than for a business that is non-union.
Value is in the Eye of the Beholder
It should be no surprise that the ultimate value of a company is often specific to the actual buyer and the transaction structure. It is important to keep in mind that a buyer may realize a completely different set of economics in the operation of the business than the seller or other buyers. A buyer may also perceive certain uncertainties to be minimal while others do not. Buyers will also have differing expectations for the payback or return on their investment. These return expectations vary significantly by industry and the economics of the buyers’ capital. A public company with a high stock price may view the cost of additional equity capital for investment to be quite low relative to the cost of capital for a private equity fund or an individual. In a sale situation, a seller, guided by his investment banker, will seek to identify the buyer’s true economics and negotiate to capture as much of the buyer’s value as possible. When preparing an abstract valuation where a sale is not at hand, any statement about value must be substantially qualified and will usually be presented as a range of potential values.
The Value in Understanding Valuation
In the investment banking community, a valuation is a first step in accomplishing a further objective, be it a sale, merger or capital infusion.
For an owner, understanding how the outside world will value their business can aid them in identifying opportunities to sharpen performance and improve positioning of the company for an eventual transaction. The actual value received in a sale will be determined by the factors identified and discussed above and the outcome of negotiations between the buyer and the seller.
Value is an important knowledge point in setting key man insurance or other planning for unplanned exits of an owner. Value is an important, and often contentious, factor should their be intrafamily disputes.
Careful analytic work can establish parameters and bracket value, but to get the “Final Answer” nothing is as clear as a completed sale resulting from a properly executed sale process. Regardless, an owner should understand and know their businesses value all along the path; anything less is flying blind.
Todd Peter is a FocusCFO Principal based in Cleveland, OH.
Reviewing quickly, we discussed the difference in a sale price and the business value. Here in article #2, we look at the methods Business Valuators use to establish a value when there is no actual buyer. Of course, the techniques are intended to simulate the rational thinking of a generic buyer. Professional valuators may apply 2-5 different methods to develop values and pick the best suited. So off we go to Valuation 101.
Cash Flow Based Valuation Techniques
Sound company valuation techniques all include a combination of Cash Flow and Asset Value as the primary determinants of value. There are several specific cash flow related calculation methodologies, each favored by different analysts, advisors, and courts. In many cases the choice of a favored technique may be more of a reflection of the desire for a specific outcome than true superiority of the method. A low valuation may be desirable to minimize estate taxes. A divorce proceeding may have one party wishing for a high valuation and the other a lower one.
There are two fundamental elements of value that are derived from cash flow and they are usually considered incontrovertible. First, value is all about how much cash a company can generate, commonly known as “cash flow” or “cash earnings”. Second, value is about the relative perceptions of the certainty of the “cash flow”. These two ideas intersect as a valuation that incorporates the future ability of the business to generate cash flow.
Looking first at the analytic methods of determining a company’s value will help to sort out some of the confusion about value. Virtually every financial valuation technique includes the idea that value is tied to future cash flows. This principle is a fundamental premise of modern economic theory (i.e. an investor wants to get a cash return on his investment). A first step in this process is separating the impact of the capital structure, the amount of the company’s debt and equity, on the cash flow of the company. Different techniques do this in a number of ways but the objective is the same: to state the cash flows on an “apples to apples” basis, adjusting for the specific debt and equity structure that exists in the company under the current owner. You will see discussions of weighted average cost of capital, leverage adjusted betas, after tax cost of capital and other financial manipulations that can boggle the mind!
One of the simpler, and thus more common, techniques is to calculate cash flow before the cost of interest and taxes, usually stated as earnings before interest and taxes or EBIT. A close cousin to EBIT is EBITDA which also adds back the non-cash expense of depreciation (and amortization if present) to calculate cash flow. We will return to the EBIT/EBITDA distinction and the vagaries of free cash flow in another context a bit further on. For now, we can recognize that “cash flow” is an underlying driver in every valuation.
The second driver of value associated with cash flow is the degree of uncertainty about the “cash flow” in the future. This driver follows the adage “less is more”. In this case, less uncertainty translates to an investor being willing to value the future cash flows higher and pay more for them. On the other hand, the more uncertain the future cash flows, the less an investor is willing to pay for them. It is a given that the future, however calculated, is a guess. The guess may be a very easy one based on an extraordinarily stable history and a dearth of external factors that could impact the future. It can also be a very difficult one due to erratic past performance and numerous internal and external unknowns.
An Idea with many Aliases
Earnings, EBITDA, EBIT, EBITDAR, Normalized Earnings, Operating Earnings, Operating Cash Flow, Free Cash Flow, Leverage Adjusted Earnings, Trailing Earnings, Pro Forma Earnings, Pre Tax Earnings, Net Income, Owner’s Benefit, Owner’s Consideration, Owner’s Discretionary Income…. In the world of business and securities valuation, a company’s ability to “make money” comes under many names.
In business valuation jargon, the value of future earnings is usually computed as a multiple of some sort of a measure of current “cash flow”. The terms that are used are numerous and the math is often a little fuzzy and can depend on whether you are a buyer or a seller, but a price to earnings ratio, a multiple of EBIT or EBITDA, a multiple of revenue, or a capitalization ratio, are commonly used to determine value. In these calculations, the higher the multiple, the higher the value assigned to the future cash flow, and the higher the value of (and presumably the more attractive) the company.
A student of corporate finance will recognize that these multiples translate the expected future stream of cash into an amount you expect to pay. Presuming that all can agree on what the future cash stream will be, than the amount you are willing to pay is determined by the perceived uncertainty that it will actually materialize and yield the expected payoff on the bet in the future. A bet on red or black at roulette has a better chance of winning than a bet on a single number!
In technical terms, the “multiple” is a mathematical result of discounting the future cash flows by an uncertainty factor known as a risk adjusted discount rate. This rate is then divided into a current “cash flow” measure. For simplicity in discussion, usually at cocktail parties or the golf club, the valuation is expressed in terms such as 5 times EBITDA or 15 times net income.
Underlying the Idea of a Multiple
Valuations expressed in terms of a multiple of current “cash flow” derive not just from our innate desire for a simplified form of communication but from economic theory that states that the value of a future stream of earnings is proportional to the “cash flow” times a multiplier. The multiplier is derived from the cost of capital and any expected growth in the future earnings stream [M = 1/(r – g) where r is a risk adjusted cost of capital and g the steady state growth rate of “cash flow”].
In summary, the cash flow methods focus on the income statement of the company, its cash earnings, and an appropriate risk factor to determine the value of a company.
Asset Based Methodologies
In the context of determining market values of a transaction, the underlying asset value is an important consideration. In certain situations, and in some industries, an asset-based value calculation becomes the methodology of choice for valuing a company.
Asset valuations generally follow one of two paths – the accounting approach or the fair market approach. The traditional GAAP balance sheet can be viewed as a proxy for the fair value of the assets of a company less any debts owed, and is sometimes used as a measure of value of the company. This is known as the book value of the company. A severe limitation of this approach is that under accounting rules, the fixed assets of a company (generally land and buildings, and machinery and equipment) are valued at historical cost less any accumulated depreciation that has been recorded in the financial statements. This can significantly understate the value of the assets because it ignores the impact of inflation over time. Machinery and equipment that has a substantial current market value may be included on the balance sheet at no value if it is fully depreciated. This often occurs with smaller companies that tend to use accelerated tax depreciation rates for financial reporting purposes. In addition, land and buildings often have a lower book value than current market value.
A modified version of this approach restates the value of the fixed assets to market value to reflect a more accurate value of these assets. The increase in value due to the restatement to market values results in a corresponding increase to stockholders’ equity or the book value of the business. The value of the current assets (cash, accounts receivable, minus account payable, and inventory) are then added to the adjusted fixed asset value to get an adjusted book value.
Reading a valuation report is often a daunting task; valuation standards and texts run thousands of pages! Just remember every technique is either trying to calculate the cash a business will generate that you can take home or the cost of replicating all the assets of the business. Its either cash flow value or asset value!! Modified, adjusted and tweaked until the picture looks just right to the valuator!
Todd Peter is a FocusCFO Principal based in Cleveland, OH.
The question of how much is my company worth is a complex one that includes many intangibles as well traditional financial factors. Like beauty, value is in the eye of the beholder and frequently depends on perspective. In the three short articles in this series we will first set the stage with some simple clarifications, then get deep and detailed in article 2, and then wrap up with some practical issues in article 3.
Value versus Sale Price
There is a subtle but important distinction between the notion of the value of a company and the sale price of a company. In the event of an arms-length sale transaction, there is a strong argument that the sale price is the value of the company. But is it really? With lower mid- market private companies (those with values under $25 million), a sale can involve a complex mix of value to the seller, delivered in both financial and personal terms, at closing and in the future. These factors can result in a difference between total value to the seller and the sale price at closing. For example, a seller may insist that the company keep operating at its present location for a period of time in order to preserve jobs for the workforce. This may result in a reduced selling price but may bring great personal value to the owner. Additional issues that can cloud the question of value evolve from the legal form of the transaction (stock versus asset purchase) or from the structure of the transfer of the total price paid (cash, assumption of debt, assumption of liabilities, etc.). These can obscure the actual value of a company to the outside world and often even to the financial press!
Absent a sale, a company’s value can be defined as what an arms-length transaction would bring in a sale or the value of the company as it is being run by the current owners. Sounds simple but there are a myriad of valuation methods and techniques to choose from. In fact, the question of valuing a company usually generates a heated discussion accompanied by enormous amounts of jargon and strident argument. This can be broken down into two basic approaches to valuation. The analytic school is based on review, analysis, and logic, and results in a defensible value for a business. This may be particularly important when dealing with estate matters involving the IRS. It often includes the comfort of professional bona fides like “Certified Valuation Analyst”. In contrast, the deal maker school points to a completed purchase agreement and a cashed check and declares that to be the value! Both schools are instructive and can provide useful guidance to understanding not just the magic value number but the analytic and evaluation processes and thinking that generally lead to determining value.
Valuation – Internal and External Factors
The most important elements in establishing the value of a company are the characteristics of the company itself. The financial performance of the company, its strategic profile, and the characteristics of the company’s industry will establish the core layers that determine the value. External factors that can move that value up or down include the supply and demand for acquisitions, the availability and cost of capital, and the state and the dynamics of the overall economy. In this discussion we focus on the intrinsic aspects of the company.
Todd Peter is a Principal with FocusCFO based in Cleveland, OH.