Successful businesses are usually valued by estimating a future cash flow using either an income approach or a market approach. The goal is to select the best cash flow to reflect the true earnings power of the business for the size and type of business and the valuation risk data available. The risk in business valuation is that projected cash flows will not be met.
Examples of alignment between cash flow and risk adjustment/ measure:
Market Method Revenues —– Total Revenues
Market Method EBITDA —– EBITDA
Market Method SDE —– SDE
Capitalization of Earnings —– Usually After Tax Cash Flow from historic data
Discounted Cash Flow —– Usually after Tax Cash Flow from projections
In all cases, the proper selected cash flow for business valuation is forward looking. We look at the past because usually that is the best indicator of the future. (This is not always the case as Covid-19 has shown us but it usually is the best that can be done.) Valuators also look at company staffing depth, systems, projections, industry growth rates and other data to estimate future cash flow.
Cash Flows Used in Business Valuation
Here are a few cash flows frequently used to measure value.
Revenues
Revenues are easy to agree on but not always an indicator of the money making ability of the business. In this case, value is much more influenced by the bottom lines, namely the income generating power of the business as opposed to the pure revenues. But, sometimes revenue is all there is compare. Certain industries such as accounting, insurance, and financial planning will often be valued by revenues.
EBITDA ( Earnings Before Interest, Taxes, Depreciation, and Amortization)
This is viewed as an indication of the income that could be available for distribution to an investor. This cash flow assumes that the company is fully managed–namely an investor that owns the company will not be working there as all management required to make the cash flow is in place. We use EBIT (Earnings Before Interest and Taxes, which does not add back depreciation and amortization) for some industries with large equipment investment requirements. If a company must continually buy new equipment, then depreciation may not be available for distribution to investors. This cash flow is generally used for businesses that are large enough that they are likely to have a corporate or private equity group type buyer that wants a fully managed business.
SDE – Sellers Discretionary Earnings
In the simplest form, this is EBITDA plus all the ways one owner makes money from the business. If there are multiple owners, the labor value of all owners beyond the first one has to be compared to salaries. Some owners are paid more than their labor value, some less. This is then added to or deducted from the profits. For smaller owner-operated businesses (whose fair market buyer is likely to be another individual) this can be the most accurate cash flow available.
After Tax Cash Flow
This measure of income is used many times with Income approach valuation methods. Income approaches tend to use buildups of layers of risk to determine a capitalization or discount rate. In effect, that rate is what an investor would need to invest in the business out of all investment options in the world. Those risk levels primarily come from public market data. Therefore, they are viewed as being after tax since public company earnings are after tax and after tax cash flow is used as it is similar to public company earnings.
Gross Profits
Some industries use gross profits after deducting the cost of goods sold. While not a bottom-line profit, it can show if the product or service of the business is profitable enough to pay for overhead and profits if volume can be increased.
Normalizing the Cash Flow
Whichever cash flow you use you will hear the term, “Normalizing the Cash Flow.” When a cash flow is normalized, it is adjusted to be apples-to-apples to reflect the earnings power of the business and be comparable to the risk factor source data. Once more, cash flow in business valuation is forward looking so the valuator is always trying to estimate future cash flow in these adjustments. Normalizing adjustments have three main categories.
Comparability Adjustments — these are made to make the data comparable to the risk data. For instance interest is often added back as an owner does not have to take on debt (under valuation theory anyway).
Non-operating or Non-recurring adjustments – these are also called one-time adjustments. For instance PPP loan income is a one-time adjustment so it is removed for valuation purposes as they are not likely to happen again in the future.
Discretionary Adjustments – these are adjustments that usually benefit the owner or the owner chooses to pay for the expense but it is not required to generate the earnings of the business. This can be things like the owner’s pension expense, underemployed family members on payroll, owner’s health insurance, etc.
In summary, the valuator selects the cash flow that will best represent the earnings power of the business being valued and has sufficient data to generate a valid estimate of value. The valuator then normalizes the company cash flow to improve comparability and show true earnings power. Finally, the normalized cash flow is adjusted by the risk adjustment to determine value.
The last step is always stepping back and asking, “Does this make sense?” Namely, is there a sufficient return to the owner/operator or investor for the risk of the investment? As I always say, valuation is an art and a science, and often experience and practice helps with understanding the art. Contact me to learn more about my valuation services or learn more about the Art of Business Valuation in my book.
In the July/ August Issue of The Value Examiner, the publication of the National Association of Certified Valuators and Analysts (NACVA), I wrote about two common mistakes I see when valuators use the income approach with small businesses. Here is an overview of those two mistakes, or you can read a PDF of the article by clicking this link:
Understanding company-specific risk in business valuation.
In my last blog post, I explored some of the concentrations and risks that small businesses face. The risks that large companies have are not the same risks that small businesses have. The income-based method captures risk with the company-specific risk premium (CSRP), but I’ve seen this understated too many times. I explain in the article that different methods will give different discount rates, and those will change the value of the company. Valuators who do not regularly value small businesses often understate the risks associated with them.
Understanding long-term growth for early-stage and growth-stage companies.
The second mistake I often see is understating the long-term growth of small businesses in an early or growth stage. For example, using a 10% growth rate in the capitalization of earnings method gives you completely unrealistic results for cash flow over time. However, because present value discounting is also part of the process, it may not give you an unrealistic business value. In the startup and growth stages of a business, that business might experience annual growth rates of 100% range or more, but often average 10–35%. At some point, the companies level off. Knowing the business growth cycle and which phase the business is in helps you evaluate cash flows and the company more accurately.
Valuation is an art and a science, and often experience and practice helps with understanding the art. Contact me to learn more about my valuation services or learn more about the Art of Business Valuation in my book.
Let’s say you are doing a home renovation. You’d expect the professionals you hire (from the carpenter to the plumber) to actually be able to do the work you need. When we hire any professional for any task, we expect them to be professionals who can do their job well.
The same is true for Certified Valuators and Analysts® (CVA’s). In fact, the NACVA’s Professional Standards says that, “A member shall only accept engagements the member can reasonably expect to complete with a high degree of professional competence.” Basically, it is unethical for CVA’s as professional valuators to say we can do something that we can’t.
However, this standard can prevent us from taking engagements that we aren’t qualified to do. So how do we take our practice to the next level? In a recent article for Association News, the newsletter for the National Association of Certified Valuators and Analysts, I suggest three main ways in which valuators can expand their knowledge, and therefore their practice.
I suggest you explore the tools that the NACVA makes available to members (and valuators should become members to access these tools). In my decades of work as a valuator, I have also found that a network of trusted peers (whether through your firm or the NACVA’s Mentor Support Program) can be really helpful. Finally, there are so many resources that others have to offer (including this blog and my book). Simply searching the internet for what you need may help you learn more.
As I’ve written about previously, the three main valuation methods each have their pros and cons. Understanding valuation means understanding when to use the Income approach, the Market Methods approach, and the Asset approach. Here are some basics about these approaches, and when to use them.
A Profitable vs. Unprofitable Business Valuation
As much as business owners hate to admit it, there are unprofitable businesses. Remember, you can evaluate a unprofitable business. It just means taking a different approach. The Income and Market approaches are primarily used when valuing a profitable business. The Asset approach has methods that tend to be used for unprofitable or poorly performing businesses with significant assets.
The Income approach uses the Capitalization of Earnings Method and the Discounted Cash Flow Method.
The Market approach uses methods such as the Revenues Method, the SDE (Sellers Discretionary Earnings) Method, and the EBITDA (Earnings Before Interest, Taxes, Depreciation, Amortization) or EBIT (Earnings Before Interest and Taxes) Method. Each method is a different cash flow, and can be used for a comparison between the company that is being valued and a comparable company.
Small Businesses Can Benefit from the Income Approach
The Income approach is the most commonly used method for small business valuation, generally using the Capitalization of Earnings method. This is usually the best approach because of its simplicity and the fact that it can be applied to most businesses.
The Capitalization of Earnings method typically looks to the past 3 to 5 years of after-tax cash flow. This is used to estimate a cash flow for the future. This single cash flow figure is divided by a capitalization rate, commonly referred to as the Cap Rate. The capitalization rate is usually estimated using a Build Up method for the different risk levels from public market data made available by many sources including Business Valuation Resources (BVR) (https://www.bvresources.com/) and Duff & Phelps (https://dpcostofcapital.com/).
The Problem with the Income Methods for Small Businesses
The methods are not always perfect for small businesses. There is no quantifiable information linking small companies to public data–they don’t have to make their information public. This is less of a problem for larger small companies (those with EBITDA above $400,000), since there are several methods that appear to provide a reasonable starting point for analysis. These include the Duff & Phelps Navigator, using the Build Up in the Risk Premium Report Study section with the Regression Equation Method button turned on.
However, a smaller company may have insufficient cash flows for any other method than SDE to work. In this case, there is absolutely no data to estimate the Company Specific Premium. The Company Specific Premium is the adjustment used to bridge the gap between the public data and small company reality. There are no third party sources of Specific Company Premium for SDE cash flows. This means for smaller companies, the Cash Flow Market Method makes more sense. Fortunately, for these smaller companies there is usually more comparable market data making this method when properly applied quite supportable.
The Cash Flow Market Method for Small Businesses
Cash Flow Market Methods review the past to estimate a future cash flow. You select a comparison set of actual reported transactions from a transaction database. Then, this set is reviewed against the company being valued and a multiplier is selected. The multiplier is then multiplied against the cash flow to find the business value. I explain a very effective methodology for selecting and reviewing comparables in my book, The Art of Business Valuation, Accurately Valuing a Small Business, which you can purchase at this link.
There are legitimate issues and concerns around quality of the comparable data when using the Market Methods. Yet, with enough data points (which doesn’t have to be that many, depending on the data set) and analysis, you can reach a high-level supported comfort. For businesses with SDE under $500,000 and EBITDA under $400,000 the Market Method Cash Flow is usually the best way to value a business.
Business valuation has never been more interesting than in 2020 and 2021. The ups and downs created by COVID-19 and the varying responses by politicians and the business community have created quite a roller-coaster. I find many of my clients, bankers, business owners and their advisors asking:
“So, where are we now?”
The current belief appears to be that the worst of the virus is behind us and we are moving into a post-COVID future in business and business valuation. It appears that the high-risk period caused by the coronavirus is behind us. If this is the case, when all things are equal, there will be little to no downward assessments when thinking about the reactions to future effects from COVID-19. Let’s hope for many reasons this optimism turns out to be warranted.
While each business and every business valuation is different (after all, that is why we do the work), I can break the current environment down into three classes.
Group One – Nothing Happened
Of course something happened: shut downs, employee safety or work from home issues, supply chain issues, new signage everywhere, and screens were just a few of the most visible things. But in the “Nothing Happened” group, the underlying company continued to deliver value to customers and clients. Any interruptions were brief and the business either made up the lost revenues or resumed right where it was on a monthly basis as soon as it was allowed to reopen or customers were allowed to leave their homes.
Companies in this category are many service providers like accounting firms, service repair companies, and basic essential businesses like grocery stores. These companies and businesses are being valued as they always were. In fact, many may have a higher value for having shown resilience in difficult times.
Group Two – It Got Really Good
Many industries and companies benefited greatly from the pandemic. For example, indoor signage companies, outdoor recreation, and clothing manufactures that produced masks quickly and liquor stores that supplied alcohol at higher rates than pre-pandemic, not to mention Zoom and tech companies of all stripes that made working from home and connecting with loved ones easier. Some of these businesses may stay strong in the “new norma,l” but many are likely to show 2021 as a bubble with exceptional results.
Valuation is always forward looking. After all, you would not make a personal investment that had paid 20% returns last year if you were told it was not going to pay anything in the future. That is the nature of value. Therefore, the issue in valuing these companies is estimating a likely future cash flow. In many cases, a review of past data can be a good indicator for a likely future cash flow. But, what about the company that doubled revenues and had 5 times the earnings of prior years? Determining a likely future cash flow for that company requires judgment. Otherwise, like the companies in the first group, the overall risk is likely to be viewed as being reduced. The likely future cash flow will (at worst) remain where it was pre-pandemic, and possibly increased post pandemic. These companies as a whole have increased in value.
Group Three – What The Hell Just Happened?
One of my favorite quotes is by the boxer Mike Tyson, “Everyone has a plan until they get punched in the face.” Group three is made up of companies that got punched in the face, and in many cases knocked out.
The results of companies that fall in this category can vary greatly depending on their location and specifics. For instance, a formal high-end sit-down restaurant in New York City would have been much more impacted than a mid-priced restaurant in an outdoor resort town that could do outdoor seating and take-out. But, all of these companies have reduced profitability to large losses. Many may never reopen. Many of the businesses in group three are in entertainment, tourism, and restaurant sectors.
Some of these companies are quite easy to value. As of a current valuation date, they have nominal or no value. Namely they may have value in the future, but they do not today.
However, others in this group are the most difficult to value as they have limped along and now have strong prospects for a banner year followed by a hoped for return to the “old normal.” Common sense says this is likely to be true but valuators are required to have a reasonable basis for their opinion.
Reasonable basis can come from many places. One of the easiest to work with is the monthly income statements that show returning revenues. Another source is well-prepared and supported projections that tie into economic and scientific data, which show a decline of the effects of the virus and a return of the economy. Again, the required evidence of a “return” is going to vary with the business and how hard the business was “knocked-out.” Yet, these companies now have a risk that they have not fully escaped. Therefore, most of these businesses will have a reduction in value from pre-pandemic for a while at least until projections hopefully become a profitable reality.
The United States and business in our country appears to be quickly returning to normal. Hopefully the vestiges of COVID-19 will quickly be left behind. But, business profitability, risk, and ultimately business valuation remains much more nuanced in a post-COVID world.
I’ve written more about COVID-19 and business valuation for BVC, the Business Valuation Resources publication, and NACVA QuickRead:
No matter what the financing event you are facing is– buying a business, selling a business, getting a loan, or acquiring a partner– you will need a valuation. Understanding how the value of a business is determined is also important because then you can feel confident in knowing what your business or the business you want to buy is really worth. And even if you aren’t ready to sell or apply for a loan yet, knowing how much your business is worth can help you plan for the future.
NerdWallet, a company that explains financial information to consumers, recently published an article that outlines the major things you need to know about small business valuation. Read the full article at this link.
They explain the terms and acronyms you’ll need to know, like SDE and EBITDA and how to organize your finances and determine your assets. They also suggest you do what we always do: find out more about your industry and what businesses of similar size, revenue, and business model are worth. They also outline three approaches for valuation, but if you want more information about these methods, you can read my recent blog post.
As they write, “No matter where you are in your business’s lifecycle, learning how to determine a business’s value is a great way to better understand your own business’s finances and assets within the context of your industry.” We always stress that Business Valuation is both a science and an art. To find out more about professional valuation services for your business, contact me to learn more.
