After a recent seminar “Valuing Small Businesses in the Shadow of COVID-19”, I took time at the end to answer some questions from the attendees. Here are some of the questions (and answers!) on using the Income Method to value small businesses that I felt might be most helpful for other seminar attendees as well as business valuators, CPAs, lawyers, and consultants that work with business valuations.
Do you believe projections and forecasts for the discounted cash flow income method of business valuation use will be less reliable during the Covid-19 Pandemic than before?
It is very difficult to estimate reliability of projections for business valuation outside of comparing a company’s prior projections with actual results. Most small companies do not have that type of data or the projections prove to be unreliable pretty much all the time. Therefore I do not believe most projections are less reliable due to COVID-19. There are reasons to believe they may be more reliable. I suspect in most cases much more thought and support will be provided in creating the projections and final forecast. For many companies, instead of being a “add 5% to last year” situation (we have all done it) much more strategy and foresight will go into the whole planning and projection process.
In all events all projections and forecasts for use in an income method of business valuation need to be reviewed carefully from the point of view of, “is this the absolute best that can be done” with what is known and knowable. In the “The Art of Business Valuation”, much time is spent on reviewing projections as it is always a difficult area with a high level of professional judgment.
Aswath Damodaran models deal with changing growth rates and discount rates in the future in order to estimate business value using the discounted cash flow income method. See his discussion of the three state dividend discount model and the H model. Do you agree?
Damodaran is clearly a sage in the field of business valuation. He deals almost exclusively with public and extremely large private companies that may go public. That is entirely different from valuing small and micro businesses typically with revenues under $10 million. Certainly if you are working with a company that can provide a quality projection as a base for use in a discounted cash flow analysis, adjusting the cash flows and the discount rates over time is a reasonable way to estimate the value. In fact, if the data is highly supportable, the discounted cash flow method is theoretically the best method. Of course this is fact and situation dependent like all business valuations.
Many Companies and most small companies cannot give you a reasonable starting point projection or forecast. From my point of view, if I do not have a reliable projection to start from, it is usually best to use a single period valuation method such as the capitalization of earnings method with proper adjustments. Therefore in the proper situations, I agree with Damodaran. But for most micro and small business valuations we will not have the starting point data available to us to use the discounted cash flow income method of business valuation.
On last comment. I will frequently run estimated discounted cash flow models with various potential earnings streams to get an understanding of a companies range of values under possible scenarios. But to me, these are sanity checks and/or information underlying my professional judgement not final valuation methods. A useful tool but if I can’t really support the cash flow, it is not a final valuation method.
Have you ever had a situation where the Company Specific Premium in the Income Method of Business Valuation is negative because risk is lower than normal?
Absolutely but it is quite rare. Every now and then we find a company that is so locked in with its customers (often referred to as “sticky” ; for example, credit card processors can be sticky because they are written into your website) and so well organized and profitable that the risk is below the average public company. But, that is very rare. If you find that company, make sure you really build a well thought out case for your adjustment because it is likely to be doubted. Clearly explain why your company is different and why it should stay that way in the foreseeable future.
More webinars on the “Valuing Small Businesses in the Shadow of COVID-19″ topic and other business valuation topics are being scheduled in the upcoming weeks. If you are interested in participating, please visit our Upcoming Events page
“The Art of Business Valuation, Accurately Valuing a Small Business” covers many aspects of small business valuation and market sales including working with business brokers, increasing sales value, descriptions of a well-run sales process, due diligence including a checklist and guidance on SBA loans.
If you value or use valuations of businesses with revenues under $10 million, you need this book on your desk. The book, published by Wiley, is available through your favorite bookseller.
Finally the author, Greg Caruso, JD, CPA, CVA, is always available to assist with exit planning, brokerage, and to prepare or review business valuations with an emphasis on increasing value and likely transaction values and terms.
How can you tell if a business valuation is correct or if it is likely to be biased, wrong, or outright rigged?
In the majority of business valuations, the business valuator follows accepted standards and delivers a supportable and unbiased valuation.
Unfortunately, a few business valuations are incorrect or inappropriate. Often this result is more because of inexperience or unrecognized bias rather than outright intention.
The wrong standard of value. Standards of value are standardized assumptions around who are the agreed upon buyers, sellers, timing, and other details of a sale. The wrong standard of value will subtly change many things in the valuation and often lead to an improper value.
The wrong valuation date. The valuation date is the cut-off date that the valuation is done through. For some valuation purposes the valuation date is critical. For instance, consider the value of a restaurant serving a tourist destination on a far-off island the month before Covid-19 shut downs and the month after. For some purposes the valuation date moves. This is common in divorce. The wrong valuation date can result in a wrong value.
The cash flow being applied against the wrong multiplier or discount rate. For instance a SDE (Sellers Discretionary Earnings) cash flow being applied to an EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization) multiplier; a non-tax adjusted cash flow being applied to a standard tax adjusted build-up. This can greatly skew value and is not always as obvious to spot as it sounds.
Too Good To Be True, almost miraculously better or worse current year (or previous year) results than earlier periods. In some industries, many aspects of the accounting statements are based on allocations that can be tinkered with. Are gross margins consistent, were all expenses entered, are the period cut-offs correct? Does the economy, industry, company factors and more support the numbers? There may be a very good reason for the change in results, but make sure the situation makes sense.
Suspicious add-backs, one-time events, and so on. Adjusting entries to create “apples to apples” financial statements for comparisons to market data or discount rate data is essential. It is also a major area for error and trouble. Make sure comparability, one time, and discretionary adjustments meet the definition for the cash flow being used and are properly supported.
Cash flow weighting that is not supported by facts. Both the market method and the capitalization of earnings method weight historic cash flows to estimate a future cash flow value. This weighting should be done to tie into expected future results as reasonably influenced by the past and future expectations. Intervening events can make historic cash flows susceptible. This calculation is easy to miss and can greatly swing results.
Hockey stick projections. Similar to miraculously better financials are projections into the future. Companies that claim they are going to “take-off” next year. Certainly that could happen but support should be very strong and the discount rate should be higher to justify a value found.
Unusual or doubtful discounts, capitalization rates, and market data multipliers. These are all adjustments to reflect the risk of making or not making the required cash flow return into the future. The comparison set needs to be reasonably tied into the situation with the subject company. While the discount rate or multiplier is a simple number, estimating it requires experience and professional judgement.
A final value after all adjustments and balance sheet adjustments that is above a 100% financed business at 8%. This is extreme, but it happens, most often with very high inventory or receivables businesses. Again, the finance method is a great sanity check. In the Finance Method rule of thumb, you work back from the cash flow to estimate the loan principal amount it will support.
Cash Leakage. At the other extreme, a long-term high revenue business in a “cash” industry with very low gross margins and no value. While it could be a huge discounter, it may also indicate cash leakage and requires additional review.
Cherry picking. Namely, almost every choice was favorable to very favorable for a higher or lower value. Consistent but unjustifiable small gains or losses at every turn can greatly change the value found.
All of these issues, other than the first two issues, could be explainable and even correct. But, if these factors are present, look hard and ask questions before signing that the value found and the report is correct.
Conclusion:
If you are reviewing a business valuation you should make sure it is correct. The book, “The Art of Business Valuation, Accurately Valuing a Small Business” has 400 pages covering many professional judgement, calculation, standards, and other important valuation issues along with access to sample reports, calculators, and checklists downloadable from the web. This will be the one book you will reach for if you value or rely on valuations of micro or small businesses with revenues under $10 million. The book published by Wiley is available at your preferred bookseller. More information can be found at www.theartofbusinessvaluation.com
Finally Greg Caruso, JD, CPA, CVA, the author is always available to prepare (or review) business valuations for all purposes and situations.
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After a recent seminar “Valuing Small Businesses in the Shadow of COVID-19”, I took time at the end to answer some questions from the attendees.
Here are some of the questions (and answers!) I felt might be most helpful for other seminar attendees as well as business valuators, CPAs, lawyers, and consultants that work with business valuations.
I know you like to reflect the impact of COVID-19 by using a discount. If sales are down 40%, are you reflecting the decrease in the cash flow too?
The first thing I do is adjust the cash flow in a business valuation to what I think is likely next year. Generally we do this through weighting a historic cash flow or using a projection. But, the intention is the same. Project the future cash flow to the best of our ability. So, if the 40% drop appears to be permanent or at least likely for the next year or two I would adjust my cash flow first.
Once I have my cash flow adjusted then I look at the risk to the cash flow in the business valuation. For many businesses COVID-19 and the possibility of a double dip recession this winter increase the risk to the cash flow. Namely, if the business gets shut down for two months due to a 2nd waive of the virus, my cash flow will have been optimistic.
For many businesses the private company market methods and the capitalization of earnings method the risk adjustments do not include this unusual COVID-19 risk. That is when I use the COVID-19 discount for lack of marketability or I use the same logic to reduce the multiplier or increase the capitalization rate. (Click Here to go to blog post on Estimating a Covid-19 Marketability Discount.)
How do you deal with the dates of transactions? Especially when using the market approach for a company in an industry that doesn’t have too many transactions reported.
My informal reviews, but certainly not rising to a study, appear to show that market method private company business valuation multiples do not vary much for small business transactions during booms or recessions.
But, the volume of transactions drops precipitously during and often for a year or two after recessions. Therefore I do not sort recessions vs. recoveries. In most cases, my first sort has a start date of 2013 “just because” that is what I do. More recent data tends to be better vetted, so if there is enough recent data, I choose to use that. In thin NAICS codes, I will go back further.
I do chart the result to see the trend line for multiplier vs. cash flow/revenues (a profitability measure) and I do look at the detailed data to see if I can spot trends or problems.
But, in many cases, I will use the older data and make adjustments based on my professional judgment. Not perfect but highly likely for smaller businesses to be closer to the correct value than other methods.
Remember, every method has problems. The best we can do is pick the best one for what we are working with.
Why do you include a sort by a minimum or maximum cash flow in Deal Stats or other comparable databases?
By including a cash flow in your sort for market method comparable companies, you obtain results more like your subject company.
Also, all of the ratios and other data will include your cash flow and be more valid for comparison.
An example of what I mean by that is if I do not include a cash flow sort, for instance, SDE (Sellers Discretionary Earnings) then when I look at the page that includes ratios, maybe gross margin, something I will look to at times, perhaps only 8 of the 12 comparables had an SDE. Well, now I have no way of knowing if the ratios I am looking at tie into the shown multipliers in the business valuation data. The four other comparables could significantly shift the data and my ability to compare it to my subject company data.
By sorting market method comparables by a cash flow, I reduce these discrepancies. The methodology to really understand and gain confidence in private company market comparables is covered in detail in the book.
What is the difference between SDE and Cash Flow?
Cash flow is a financial indicator of earnings used in business valuation. Many different indicators usually derived from the Income Statement may be used. The most common are EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) and SDE (Sellers Discretionary Earnings).
When normalized or adjusted so we have an apples to apples comparison between our Subject Company and the Comparison Companies, they are felt to be reliable indicators of the earnings power of the business.
Other cash flows that can be used include Revenues, Gross Profit, and Profit. Sometimes the amount actually distributed to shareholders is used.
In any event the Cash Flow is then adjusted for Risk (which is the market perception of the likelihood that the cash flow will be earned) to come up with the final value. This is all very basic at the “rule of thumb” or guess level and very complex at the Opinion of Value level.
Normalization, adjusting cash flows, weighting cash flows, and selection of a multiplier is covered in the book and again, starts simple but is beyond what can be easily written in a blog post.
More webinars on the “Valuing Small Businesses in the Shadow of COVID-19″ topic and other business valuation topics are being scheduled in the upcoming weeks.
“The Art of Business Valuation, Accurately Valuing a Small Business” covers many aspects of small business valuation and market sales including working with business brokers, increasing sales value, descriptions of a well-run sales process, due diligence including a checklist and guidance on SBA loans.
If you value or use valuations of businesses with revenues under $10 million, you need this book on your desk. The book published by Wiley is available through your favorite bookseller.
Finally the author, Greg Caruso, JD, CPA, CVA, is always available to assist with exit planning, brokerage, and to prepare or review business valuations with an emphasis on increasing value and likely transaction values and terms.
Recently I presented “Valuing Micro and Small Businesses in the Shadow of COVID-19″ as a webinar training for Business Valuation Resource members. As always, I provided time at the end of the session for questions from attendees. This group had some very thoughtful questions. I thought perhaps others would benefit from our discussion.
What do you mean by “poor financials?” Do you mean a lot of personal stuff is run through the business? Or a general ledger that doesn’t balance and off balance sheet assets / liabilities?
Each of those issues creates poor financials plus many more. Many micro and small business owners manage by walking around. They have a few leading indicators they watch (maybe sales, collections, production). From those, plus being in the middle of the business, they know how they are doing. This knowledge does not translate well for us, as we are not in the middle. Therefore, we have to work harder to really understand what is going on and how to adjust the deficient financials so they are reasonable and workable.
What sources of data do I use for the local economy?
I use the Federal Reserve Beige Book, published for each district. It is anecdotal information but I find it useful.
Another one I will use for cyclical and real estate related is State Board of Realtors sales data. Often this can be obtained at a local level, if that is more meaningful for your company. The data here impacts everything from construction, remodeling, furniture sales, equipment sales, etc. in a local or state market.
Also, the quarterly BizBuySell Insight Report offers data on many market areas with prior reports available for many years to allow comparisons. The number of sales can be used as an indicator of the difficulty or ease of selling a small business.
Local information can be gleaned from many sources. Many federal agencies, states, universities, and state oriented non-profits publish data that might be indicated for the Company and industry you are valuing.
I have been spending more time analyzing debt service (for example: Can they pay back the debt? If so when will they achieve a profit given high debt levels? Will they need more debt to stay afloat?). Do you have any thoughts on that?
Certainly for high debt companies, or companies with lumpy cash flows, (i.e. a few large clients or projects that have endpoints like construction contractors that do a few large projects each year) understanding the balance sheet is very important. Current assets on the balance sheet (particularly cash reserves) provide resiliency and the ability to meet payments when times are tough.
Another thing that needs to be reviewed with companies with debt is the terms of the debt. Many small companies use lines of credit like long term financing. Also, even long term loans often contain clauses allowing the lender to recall the entire amount due, if covenants like minimum earnings are not met. The result can be a company that is meeting minimum cash flows to survive falls into default on their loans creating serious going concern issues.
In most cases (but not all), we do not have data to make a final determination on going concern issues. But a company that has a reasonable level of going concern issues is going to have a steep discount versus companies with a clear path forward.
I saw a few companies with low, negative earnings (-30% to 50% and high revenues multiples in the range of 3-4x. This looks funny for a service company. Since I don’t have historic data or projected data how can I make sense of the pricing relationship?
Without more data, I’m not sure. And perhaps you can’t. Some technology codes do have the types of companies desired by Google, Apple and the like and these may contain synergies that frankly I don’t completely understand how to assess.
Assuming there are enough comparables, I recommend several things though before you throw up your arms in defeat.
Try sorting the data several ways. Use different cash flow minimums and minimum and maximum revenues and see if the results look different. Sometimes I get an understanding of the data doing this and it is easy within the DealStats .
Assuming your firm is profitable sort with a minimum cash flow that is somewhat near your cash flow (i.e. if your company as a 15% SDE profitability (SDE/Revenues) and a minimum revenue sort of $1,000,000 then perhaps you require an SDE of $75,000. Since your company is profitable, these comparables will be more like your company.
Always chart the companies by cash flow profitability (Cash flow being used/Revenues). This will usually provide clear trends that are different from what might be implied by the charts shown in the various databases.
Three more webinars on the “Valuing Small Businesses in the Shadow of COVID-19″ topic are scheduled in the upcoming weeks.
“The Art of Business Valuation, Accurately Valuing a Small Business” covers many aspects of small business valuation and market sales including working with business brokers, increasing sales value, descriptions of a well-run sales process, due diligence including a checklist and guidance on SBA loans.
If you value or use valuations of businesses with revenues under $10 million, you need this book on your desk. The book published by Wiley is available through your favorite bookseller.
Finally the author, Greg Caruso, JD, CPA, CVA, is always available to assist with exit planning, brokerage, and to prepare or review business valuations with an emphasis on increasing value and likely transaction values and terms.
This month’s Business Valuation Update published by Business Valuation Resources (BVR) featured my article about implementing a “COVID-19 Marketability Discount”. This is a Discount for Lack of Marketability (DLOM) that arises due to an unusual amount of risk because of COVID-19 and the related economic fallout affecting small and micro businesses.
The methodology used to determine a COVID-19 Marketability Discount can be applied as a separate discount or it can be used as a basis to adjust the historic information based market method multiplier or income method company specific risk premium (SCRP). In many current situations, due to the risk presented by COVID-19, our historic data sources (market method data bases and income method build-up data (BUM method)) do not adequately address the short term risk that is currently being placed on small businesses and their valuations
Micro and very small businesses generally cannot provide forecasts. Therefore the valuation analyst has to use a single period valuation method. As is always the case, the cash flow should be adjusted to reflect the most likely future. But, if the analyst believes an economic recession or 2nd waive of the virus could further impact cash flows there is likely to be more risk to these future cash flows than that reflected in the historic data. Assessing that risk and making an appropriate adjustment is the purpose of this COVID-19 Marketability Discount.
Alternative method: In a new article, an analyst reports that he has been using a “COVID-19 marketability discount” on control interests to make the extra risk adjustment.
“In many situations, I favor the methodology of showing a separate COVID-19 marketability discount,” says Greg Caruso (Harvest Business Advisors), “because it clearly shows the valuator’s thought process and the actual discount being applied for the current high level of uncertainty.”
His methodology is based on the weighing of factors such as those used in Mandelbaum and the IRS DLOM Job Aid but with categories modified to fit the current situation.
Caruso first developed this technique to use in a valuation for an SBA loan. The company was temporarily shut down and appeared to be fully recovered on a monthly cash-flow basis for the two months after reopening. Yet, there was still risk of another shutdown and customers would have economic issues if a recession hit, so Caruso’s basic capitalization rate was a buildup for “normal times,” which included a normal company-specific risk that he further discounted by the COVID-19 marketability discount.
Caruso explains his methodology and presents a case study in more detail with a sample analysis in the November 2020 issue of Business Valuation Update.”
I am grateful to BVR for their support through the years. They are truly a valuable resource.
In the upcoming weeks, I will be conducting several webinars on this topic. Please visit the Events Page for more details.
The book, “The Art of Business Valuation, Accurately Valuing a Small Business” has over 400 pages covering many aspects of small business valuation and market sales including working with business brokers, increasing sales value, descriptions of a well-run sales process, due diligence including a checklist and guidance on SBA loans.
If you value or use valuations of businesses with revenues under $10 million, you need this book on your desk. The book published by Wiley is available through your favorite bookseller or directly from Wiley.
Finally the author, Greg Caruso, JD, CPA, CVA, is always available to assist with exit planning, brokerage, and to prepare or review business valuations with an emphasis on increasing value and likely transaction values and terms.
“The Art of Business Valuation, Accurately Valuing a Small Business” covers many aspects of small business valuation and market sales including working with business brokers, increasing sales value, descriptions of a well-run sales process, due diligence including a checklist and guidance on SBA loans.
If you value or use valuations of businesses with revenues under $10 million, you need this book on your desk. The book published by Wiley is available through your favorite bookseller.
Finally the author, Greg Caruso, JD, CPA, CVA, is always available to assist with exit planning, brokerage, and to prepare or review business valuations with an emphasis on increasing value and likely transaction values and terms.
Greg is available for interviews, podcasts, quotes, presentations and more. Contact Greg at or 609-664-7955.
