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.