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.
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.
“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.
I am grateful to my friend and colleague, Ron Rudich, for writing the Foreword to “The Art of Business Valuation: Accurately Valuing a Small Business”.
FOREWORD
This book, The Art of Business Valuation: Accurately Valuing a Small Business is an important guide and desk reference for valuing small businesses under $10 million in revenues. The vast majority of businesses are this size, yet most business valuation books, even the ones claiming to be for small businesses, do not address the unique factors impacting these small and very small businesses.
The author’s business broker and valuation background provides a practical view of technical valuation issues from someone who has had to then “find the number” in the market. Yet this is not a book about price. It is about business valuation, namely, finding a business value for a specified interest as of a specified date to a specified standard of value.
My contribution to this work has been to provide insight and modification as an experienced practitioner, instructor, and mentor from a more technical accounting business valuation view.
The book’s focus on small businesses does not mean that methods or techniques have been simplified or ignored. What has been provided is a thorough examination of how valuation methods really work with the data that is really available for these businesses. Things like,
how to work with less than perfect financial information
how to find a highly supportable multiplier using available data
when to use the market or the income method
how to meet valuation standards
and more.
Included in the book are detailed figures, tables, explanations, and on the related website working Excel files and even sample reports that provide a framework that can be adapted to most business valuation needs.
Lastly, while an exact “opinion” may only be supportable and not be accurate, our methods, work product, and reports can and should be accurate. That is the standard we all must strive for every day in every engagement. That is why accurate is in the sub-title.
Clearly, the best a valuator can do is issue an “opinion.” Therefore, there will be varying viewpoints on the topics and methods presented here. In fact, there will be situations where the facts and assumptions would dictate that we use different techniques than the ones recommended here. That illustrates the importance of professional judgment.
That is the Art of Business Valuation.
We find this variety of viewpoints and challenges to our thoughts to be exciting and invigorating. It makes business valuation better. With this view in mind, please contact us at with your thoughts on the book and the valuation of small businesses. We also would be pleased to receive additional reports, studies, techniques and other viewpoints that can be posted on our related website www.theartofbusinessvaluation.com.
This way, we can all continue to learn, grow, and improve together.
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.
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 also available for interviews, podcasts, quotes, presentations and more. Contact Greg at or 609-664-7955.
Coronavirus, caused by Covid – 19 has raised new issues to consider when preparing business valuations. Many businesses are going to struggle to stay in business to hopefully rebuild business value on the other side of this contagion. A few considerations for business valuations in a world with Coronavirus are below.
Known or Knowable – It may be unclear when the effects of the coronavirus become known or knowable as it affects business valuation. In addition we clearly do not really know what is going to happen next (perhaps better or worse) at this point from Covid – 19. But, we need to address it based on what was known or knowable as of our valuation date. Here is a timeline from the New York Times giving some key dates and history of official actions on the coronavirus that could be useful for business valuation. Was this known or knowable on January 31, 2020, February 28, 2020? I’m not sure. It certainly was known by March 15, 2020 when the CDC recommended restricting gatherings to 50 people or less. Is this actually a regional issue? In New York area it was clearly a problem in early March. In Colorado things seemed normal in many places until mid-March.
Handling subsequent events – Until the effects of the virus on the economy were known or knowable as of the valuation date the Covid – 19 issue is a Subsequent Event. Subsequent events are events that probably would change the business value found if they were considered but they are not considered because they are after the valuation date, but obviously, before the report issue date. Another question is just how serious a warning do you need to give about the affects of coronavirus in the business valuation. For many industries and businesses this is a huge adjustment not just a little more or less risk. I recommend giving a clear analysis that the effects on the economy as a whole are going to be very large and work down to the business at hand while making it clear this has not been factored into the final business value found.
Business valuation methods depend on modeling. When business valuation models become unreliable due to the effects of coronavirus the results of business valuations become unreliable. Here are some charts and commentary on the current state of the economy the impact business valuation. Note that these results are beyond what economists or business valuation experts know how to model as they are outside anything ever seen.
Business Valuation is about predicting future cash flows. Issues in predicting future cash flows include:
How quickly can closed businesses bounce back? Initial thoughts were that business will bounce back very quickly but that is seeming much more unlikely as the economy falters and the likely time periods for stay-at-home orders and the like looks longer.
When will this lock-down end and recovery begin? One month, two months, three months?
How much of a hit are operating businesses going to take to cash flows? Is this cash flow hit going to be merely timing as collections get deferred but paid, reduced revenues do to lower sales, or will work be delivered but then clients then are unable to pay?
A liquidity crisis is brewing as the inability to pay debts and rents due to layoffs etc. increase. This will reduce payments throughout the economy even in industries not directly affected. It is unclear how this will impact other industries not directly affected and eventually the economy as a whole. A prime example of what is to come is the tremendous and quick reductions in tax revenues to state and local governments. These entities as a rule need to balance their budgets and budgets are collapsing. This will lead to deep cuts and payment issues. You can Google coming tax issues for your state and here is a link to a Pew Charitable Trust Article.
Discount rates and related capitalization rates and multipliers will need to be adjusted for the increased risk business investors face. The VIX index which measures implied volatility was in the 12 to 18 range in January 2020. It measured 66 on March 20, 2020. Click here to see the VIX chart. This indicates extreme uncertainty. Risk in business valuation and finance is the perceived likelihood that a financial return will not be received. The higher the risk the lower the value. Right now it is very difficult to estimate an appropriate discount rate or other risk rate.
Marketability discounts – Should additional marketability discounts be taken. Public stocks as a group are off by at least 30% from their highs. They can be liquidated quickly. Right now there are unlikely to be market buyers for private companies unless the buyer can “steal” something. The buyer’s rational is that is the only way to avoid insurmountable risk. The buyer may still get hurt if the company requires more cash infusions than planned to remain in business. This implies a marketability discount possibly in addition to an increased discount rate.
Business resiliency – most businesses in America are service businesses. How will reductions in force, layoffs, downsizing, and the like affect the ability of companies to restart and grow when this ends. How long will it take to retrain and get systems operating again. For most businesses their intellectual property (systems, specialized knowledge, customer quirks etc.) goes home every night and if it does not come back what will happen?
How will death affect the living – One thing that economists have not started looking at is how will the effect of 100,000, 200,000 or possibly a million deaths from coronavirus affect the living. Common sense says it will change habits and patterns but how? I live in central New Jersey. Death is getting very real here.
The net effect is uncertainty is off the chart and it is almost impossible to value a business with a valuation date of March 15, 2020 or later in most industries. Of course, in some cases business valuation professionals will have to do the impossible.
