The hard thing about valuing a business lies in the great unknown of future cash flows and the risks associated with being able to generate future cash flows. While historical operations can provide a sound starting point to determine future cash flows, it can also be very misleading. For example: a biotechnology company in an early stage of clinical trials has no historical positive earnings or cash flows, but may hold an extremely high market valuation based on the promise of future cash flows from the eventual production and sales of a new drug. Or conversely, a cemetery operation may have a one-time event due to a liquidation of real estate holdings (held for a long time), which will be nonrecurring. Hence, future cash flows can be distorted by historical events that are nonrecurring (positive or negative). The key lies in the ability to calculate a core or operating cash flow figure on which to base the valuation.
Through this post I share some little tips and trick to uncover lies behind the shady—unknown of future cash flow I mentioned on the preface which is the key basis in determining the most appropriate business value. Read on…
Adjusting Cash Flows To Be Used As A Business Valuation Basis
The following points, by no means all inclusive, provide a flavor for how cash flows can be adjusted to be used as a basis when determining the most appropriate business value.
Expense savings – One company may be interested in acquiring a business that offers tremendous expense savings opportunities via implementing the concept of economies of scale. By combining the two entities, an unprofitable business now may actually produce a positive cash flow (which has value). The elimination of duplicate accounting functions, human resource tasks, distribution facilities, and so on are often cited in business acquisitions and can assist in supporting the valuation calculated for the business being acquired. Easy targets include duplicate business overhead functions, such as accounting and finance, because, generally speaking, two CFOs or even two accounting departments aren’t needed in the combined entity moving forward.
Added expense removal – Pushing through other or personal expenses in closely held businesses has been around as long as the IRS (actually longer). Generally, these expenses aren’t necessary for the ongoing business to operate, but the owners take advantage of the tax break. Removing these expenses to increase cash flows can lead to higher business valuations. Examples of these types of items include retaining family members in various administrative or clerical positions that are more of a luxury, inflating owner salaries, or passing through various personal expenses associated with travel, autos, and so on. Of course, nobody is questioning the legitimacy of these expenses for tax purposes, but I have yet to find a company that does not test these waters somewhat.
Potential cost increases – Certain companies may be at a stage where a significant reinvestment in capital equipment, assets, and so on is required to continue to support and generate cash flows. You need to factor in these one-time expenditures into a business valuation model to reflect the impact on future cash flows. While depreciation expense is added back to determine the proper EBITDA, this figure can also be reduced in the scenario where significant reinvestments in fixed assets are required to keep a company competitive, such as upgrading its facilities to meet new environmental regulations.
Hidden assets – Certain assets may have a significant value present external to the core business. For example, a company may have purchased real estate years ago for future business expansion, but the property is no longer needed internally. To an outside party, the value may be substantial, and, as such, this hidden value needs to be reflected in the complete business valuation. Or conversely, this asset may be excluded from the business valuation and carved out from any potential analysis to capture the core value of the business.
Intangible assets and/or intellectual property – Brand names, research in process, patents, trademarks, contracts for retail shelf space, and similar types of assets have the ability to generate significant cash flows if managed properly. While one company may struggle with generating adequate cash flows, another may prosper by applying its marketing or financial muscle to an intangible asset.
Lost future business – In service organizations, a business valuation may decrease as a result of a key principal leaving or retiring. Anyone who has evaluated an acquisition within the service industry knows how critical this issue can be in terms of negatively impacting future cash flows. If a partner of 30 years leaves, chances are a portion of his accounts will also leave, which in turn produces reduced future cash flow.
This list could go on and on. When a business is valued, all elements and facts of importance must be evaluated in terms of determining what is the most reasonable future cash flow stream that can be expected. From a logic standpoint, it’s relatively easy to understand why a seller of a business would want to maximize the cash flow stream, or EBITDA, because a higher valuation would be received. Conversely, it’s also just as easy to understand why a buyer of a business would want to minimize the cash flow stream or EBITDA because a lower valuation would be provided to the seller.
Factors Influence The Multiple-applied to The Cash Flow Stream
To increase the value of a business, a higher multiple applied to the cash flow or earnings stream is desired. Conversely, in order to decrease the value of a business, a lower multiple is used.
The following list, which isn’t meant to be all inclusive, covers factors that influence the multiple applied to the cash flow stream:
Interest rates – Interest rates, simply stated, represent the cost of capital. For our purposes, the most common reference point for interest rates is the prime rate as established by the country’s largest banks. In today’s relatively stable interest rate environment, you can expect reasonable cash flow multiples. However, when the Federal Reserve Board even mentions that rates may rise, it should come as no surprise that valuations may be pressured lower rates rise, business valuations decrease. This concept is based on the premise that the opportunity cost for the funds used to buy a business will be higher, and, with all things being equal (including the EBITDA of a business), the valuation must be lower to produce the desired return.
Growth potential – Higher growth opportunities translate into stronger future cash flow potential and demand higher multiples. Just ask the dotcoms of the late 1990s and early 2000s about how they received astronomical valuations based on the premise of extremely high future growth rates. From a business perspective, the more information, support, and data that you can provide a potential buyer about the growth prospects of your business, the higher business valuation you will receive.
Length of cash flow stream – Cash flow streams that are longer and more secure or reliable produce higher valuation multiples than shorter, uncertain cash flow streams. If a company has patent production in place for the next ten years (supporting the cash flow stream) versus three years, it’s safe to say the valuation multiple will be favorable. This concept is commonly referred to as an Evergreen income stream. Just as it sounds, if you can produce cash flow streams that are forever green, cash flow multiples will increase.
Liquidity of investment – If an investment is readily liquid with multiple buyers available, a higher multiple is generally provided. Non-liquid investments with limited market appeal increase risks and drive down valuation multiples. This concept is especially true on Wall Street, where the most widely held and largest publicly traded corporations may receive a higher valuation given the ability to readily sell investments on the open market.
Management continuity – Management resources, experience, talent, and continuity represent critical elements of the business valuation process. In the infamous words of Gordon Gecko played by Michael Douglas in the movie Wall Street, nobody wants to buy or invest in a company that represents a dog with a different set of fleas. If the management team isn’t qualified to operate the business and produce continued cash flow, the multiple applied to the cash flow stream will suffer.
Concentration or diversification risks – The higher the concentration or diversification risk, the lower the multiple. Two like companies with the same cash flow stream operating in the same industry may receive different valuations because one company may generate its revenue equally from 100 accounts and the other from just 10 accounts equally. The impact of losing one account in 10 is far greater than 1 in 100 and increases the concentration risk. While it may be nice to generate 35 percent of your revenue and earnings from the Home Depots of the world, increased operating risks are present that may actually deflate the value of your business.
Timing is everything – Just about everyone has heard this phrase at one time or another. For business valuations, timing really is everything in terms of driving higher multiples and increased liquidity. You need look no further than the robust valuation period experienced in the late 1990s that crashed within a period of roughly 12 months with the start of the new decade. Capitalizing on or missing the window of opportunity can significantly influence the multiple received.
The determination of the multiple to be applied to the cash flow stream really boils down the risks present, actual and perceived:
- Actual risks are relatively easy to understand and quantify and, as such, can be applied to the determination of the cash flow multiple in a relatively logical fashion.
- Of greater uncertainty are the debates that inevitability occur about perceived risks. These risks are much more subjective in nature and, if not properly managed and presented, can significantly impact the value of a business. Needless to say, the higher the risks, the lower the valuation multiple received, which in turn drives a lower overall business value.
There are no set rules in the business valuation game. While a seller may want to maximize cash flows and lower the risks (thus increasing the value), the acquirer may want to deflate potential future cash flows and increase the perceived risks (thus producing a lower value). Or, conversely, an estate may want to justify a lower valuation to reduce potential estate taxes, whereas the IRS may be more aggressive and increase the valuation for obvious reasons.
While the basic principals used in the business valuation process are relatively constant, cash flow and how the EBITDA and multiples are managed or manipulated represent the real basis of valuing a business.
To realize the maximum valuation for a business, you must properly package, prepare, and present the business. This preparation goes well beyond getting your financial and accounting house in order because the business valuation and sales process involves a significant amount of subjective elements beyond just the numbers. You wouldn’t expect to realize the highest value when you’re selling a home that has a leaky roof, weeds growing in the yard, and clutter thrown about. Nor would you expect to receive a reasonable offer for your business with personnel or management shortcomings, excessive expenses, or improperly prepared and presented financial information.
Timing, as they say, is everything, and, while important when valuing and selling a business, preparation and presentation are just as critical! To this point, external professionals are often used to assist with this function. Top realtors often generate higher values (even with their commissions) for real estate properties if they know how to market and sell the properties. The same logic holds true for selling a business as the top business brokers, investment bankers, and/or mergers and acquisition specialists can enhance the value of a business and produce greater returns for the seller.
Final Thoughts On Successful Business Valuations
Somebody once came up to us and raised the question as to why the equity or net book value of a business isn’t equivalent to its fair market value. Valuing a business based on its net book value sounds simple enough and would seem to make sense because, if the assets and liabilities on the balance sheet are fairly stated, the business should be able to liquidate with the remaining cash equal to the net equity of the business. But rather than look at it in this fashion, I suggest an alternative view:
If you could receive a cash flow stream of $100,000 per year from assets that have a stated value of $50,000, not only would you be willing to purchase the assets for $50,000, you’d most likely be willing to pay ten times this amount. OR, if an investment generated $50,000 in annual earnings but was going to cost $2 million, would you (or any other entity) actually pay $2 million, or would an attempt be made to drive the price down to, say, $500,000 to better equate the return with the investment?
Valuing a business isn’t based on supply side economics (if it costs X, it will return Y in cash flow). Rather, the cash flows and earnings of Y determine the value of X.