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.
“Your key people are all going to retire when you sell the business? Who the heck is going to know how to run the business?????” This is not a conversation that you want to be having as a buyer or seller.
If you are trying to buy or sell a business, you know that the key people who make the business run can be an important part of the value of the business. For most small businesses the value of the company goes home every night and you hope it comes back the next morning. Of course, now the employees may just work from home and not come in but the concept is the same — employees are a huge part of a business intangible value. As a seller, your business has more value if your quality staff is staying after you leave. Your business cannot function without knowledgeable management and trained competent staff that are reliable. Here are 4 ways key people fit into business valuation.
Employees are part of the valuation.
Businesses are people applying processes to make profits. Looking at the basic market method business valuation equation, Cash Flow x Risk = Value, employees impact BOTH sides of the equation. On the one side, employees drive the processes that create cash flow. On the other, the risk of loss of the institutional knowledge that is in your employees heads is a huge factor in the risk component of value.
Employees create value.
Few small businesses make money based on their hard or fixed assets. Yes, you need those assets, but ask most clients why they use a certain business and you will hear, “We use this business because they provide great service.” Great service comes from good people. The price may count, but quality includes the quality of the service your people provide.
Employees are related to growth.
In addition to quality management, more focus is currently being given to mechanics and trained technical staff. The ability to find and keep new trained or even trainable personnel is one of the biggest growth limitations.
People are your value.
While many owners can’t imagine it, the business is not the owner. In fact, in order to have value a business must be able to operate without the owner. Therefore you must keep your people. In a recent post, I explored how you can create value through your employees (which is something you need to do long before you begin selling your business).
When we evaluate businesses, especially for tax and gift purposes, employees represent the single most important factor when calculating a business’s intangible value. This is value that you want to keep for yourself as your business grows or a value you want to include for future partners in or owners of the business.
Contact me today to learn more about business valuation and what your company is worth.
By Greg Caruso, JD, CPA, CVA, The Art of Business Valuation, Harvest Business, LCC.
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.
Have you ever asked yourself: how will I ever clean up this financial statement mess for a business valuation? You are not alone. Many small companies have notoriously improper financial records and error filled financial statements. This is often caused by a lack of understanding of what is required to have proper financial records. It is also caused by the drive to keep overhead as low as possible, which is an admirable goal that sometimes goes too far. If the company is profitable, the owner and management may get away with sloppy records until they need to apply for a bank loan, add a partner, or perhaps sell the business; or they need a business valuation for another reason.
One of the primary differences between valuing micro and small businesses and larger businesses is the quality of financial statements. Larger businesses tend to have reviewed financial statements at the very least, while many have audited statements. These businesses have true accounting and financial departments and people with the skills to keep proper GAAP records– or at least to understand and report the variances.
One of the nice things about running a small business is you get to run it your way. But, when third parties need to review your financial statements, you need to do it their way, at least to a certain degree. Here are some ways to get these financial records in shape for someone else to use them.
Know the limits of cash basis accounting.
Cash basis accounting is one of the most common things we see with small businesses. This is an accepted method of accounting, but it might not give useful financial information for many purposes. Cash basis is particularly prevalent on tax returns used to value small businesses since the cash basis better aligns tax liability with the receipt of money to pay the taxes.
For example, if the company being evaluated has large accounts receivables but the timing of collection varies, it can be difficult to get a complete picture of the true underlying cash flows. This is because accounting periods have end dates, but ongoing businesses do not have end dates. Each of these accounting period end dates represents a cut-off, but we don’t know what happens the next day. An income statement that ends on December 31 will not show a huge receivable collected on January 5, and therefore is not a complete picture.
Be aware of outright accounting errors.
Outright errors on company financial statements present another issue for business valuation of a small company. The valuator or other reviewer must always be on the outlook for material errors. Usually these errors are accidental, but may not always be. Errors often even show through on tax returns prepared by third party tax preparers. Some common errors are:
Overstating the cost of goods sold and understating inventory. This practice reduces profit and therefore taxes. Often companies only overstate a small amount of goods sold each year, but over time this can become a big problem. Take a small retailer with $300,000 of inventory and $90,000 of profit each year for example. If they overstate the cost of goods sold by $30,000 for 10 years on their tax return, by the tenth year, they will not have any inventory for tax purposes. However, they would still have $300,000 of inventory on the floor and in the back room. They will have also understated profits by $30,000 per year, or 25% per year–a significant percentage. Over the 10 years, they will reduce profits by $300,000. This can create both valuation and tax problems if discovered.
Failure to show inventory at all. This just creates a complete mess for inventory rich small businesses. In many cases, it leaves the company unable to be valued, obtain a loan, or be sold.
Failure to write off un-collectable accounts receivable under the accrual method. Some businesses never write off uncollectable accounts receivable. This causes income to be overstated. This is usually fairly easy to adjust if underlying data about accounts receivable is properly tracked.
Expenses being recorded under a variety of names. We have seen office rent shown as rent expense, mortgage payments, and lease expense all in the same year for the same company. Those types of errors make it hard to review the data for consistency and figure out what the real amount is if an account needs adjustments.
These are just a small sample of accounting errors that impact financial statements and tax returns used in business valuation of small businesses. As the old computer programming adage goes, “Garbage in – garbage out.” In most cases, with care we can clean these mistakes up and feel comfortable that the financial statements reasonably represent the company that is the subject of the business valuation. But in some cases, we may have pure garbage that may make giving an opinion of value in a business valuation impossible.
I’m a JD, CPA and Certified Valuation Analyst, and I know that business valuation is both an art and science. To find out more about professional valuation services for your business, contact me to learn more.
The Value Examiner® is an independent, professional development journal dedicated to the exploration of value and its ramifications for consultants published by NACVA (National Association of Certified Valuators and Analysts)
I am pleased to announce that I have been chosen to write a column on Small and Micro Business Valuation issues for “The Value Examiner” starting with this most recent edition.
In “Size Matters -Valuation of Small and Micro Businesses”, I will focus on matters of particular importance to businesses under $10M in revenues.
In the November/December issue, I present a case study of a recent valuation of a general contractor with a 6/30/2020 valuation date, near the peak of uncertainty from Covid-19.
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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