Questions and Answers – Market Method of Business Valuation
Valuing Small Businesses IS Different.
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.
If you are interested in participating, please visit our Upcoming Events page.
If you are interested in arranging a training on the COVID topic or other valuation topics, please visit our Presentations Page and connect with Greg to discuss your group’s needs.
“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.
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