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.
JOIN our email list to stay current on changes in small business valuation, including how to address changing business valuations because of COVID-19.
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.
Small Business Valuation 101 explains estimating your business value or worth.
Business valuation at the rule of thumb level is very simple like the summary shown immediately below. Yet formulating an opinion of value can be endlessly complex. Part of the complexity comes because business valuation is forward looking. Likely foreseeable cash flows, not past cash flows are the basis of the value. That alone brings many assumptions into play and room for disagreement.
So here it is – Business Valuation at it’s simplest:
The subject company or company being valued iscomparedto something else to determine value. For instance:
Under the asset approach the comparison is the cumulative total asset value less total liability value. (Add up the current “market” value of all your assets. Subtract all your debts. What is left is the business value under the asset method. For instance, Cash is $100,000 plus Trucks $50,000 plus Inventory of $200,000 equals $350,000 less accounts payable and debt of $100,000 means the business value using the asset approach would be $250,000.
Under the market approach you are comparing market sale comparables to the subject company. Find “comparable companies” that sold. Determine how much they sold for compared to their “cash flows”. This ratio is called a multiplier. Multiply that multiplier times your company cash flow to get a value. For example Joe’s garage sold for $300,000. Joe’s garage had cash flow of $150,000. The multiplier is 2 estimated as $300,000/$150,000. Your garage has cash flow of $125,000. Your garage’s indication of value is $250,000 estimated as $125,000 * 2.
Under the income approach it is comparing all investment opportunities to the subject company. One way to do this is to come up with a required return to obtain an investment in the subject company based on risk. Divide your cash flow by the required return. For example Cleaning Supply Distributor has cash flow of $500,000. The capitalization rate is estimated at 20%. $500,000/.2=$2,500,000.
That’s it at the simplest level. But life and businesses are not so simple. In fact each of these simple steps above combines many other steps, research, assumptions etc. Therefore, business valuation is not really quite so simple either. What is shown above is an useful place to start but certainly not the place to stop. Keep reading if you want to know more.
Three Main Valuation Approaches
The Asset Approach, the Market Approach, and the Income Approach.
One of the most important decisions a valuation analyst makes is which approach and then which method under the approach to use. Methods are subsets of an approach. Methods under an approach often share key elements of the approach but have different details and can result in very different values for the business.
Asset Approaches
The asset approach compares the value of the assets less the value of the liabilities (debts) of the company and the difference is the company value. The formula is Assets – Liabilities = Value. The assets and liabilities are often valued to different standards. A few of these standards are; book value defined as what it is on the accounting books, market value or what the asset would cost from a dealer, or various liquidation values depending on how fast the assets need to be sold. For small and very small businesses this analysis tends to leave off the value of intangible assets and is often used for liquidating companies. Going concerns or companies expected to continue operations use the next two approaches.
Market Approaches
The Market Approach compares market prices, either public stock prices or sales of comparable private companies to the company being valued. The underlying principal is Cash Flow times a Multiplier which is derived from the comparable data equals Value.
Cash flow for the future is estimated from past adjusted cash flows. Normalization adjustments are made so the cash flow is an apples to apples comparison with the comparables’ cash flows used to determine the multiplier.
The multiplier is calculated as Sales price / cash flow. For example a sales price of $1,000,000 / a cash flow of $350,000 = a multiplier of 2.85. This ratio is called a multiplier. Each comparable transaction will have a different multiplier. This multiplier is further adjusted based on similarities and differences between the comparables and the company being valued. The final selected multiplier is multiplied by the subject company estimated cash flow to calculate a value. Cash flows typically used include revenues, EBITDA (earnings before interest, taxes, depreciation, and amortization) and SDE (seller’s discretionary earnings or EBITDA + all the ways one owner makes money from the business). The analyses for both cash flow and selecting the correct multiplier can become quite multifaceted.
Income Approaches
The Income Approach estimates a rate of financial return called a discount rate that investors will require in order to invest in the subject company. In the simplest shorthand the normalized future cash flows are divided by the discount rate to calculate value. These investors are generally assumed to not be owner operators but true investors.
Data about required returns for investors is used to “build up” a discount rate which is in effect a required rate of return for investors. For instance Federal treasury bills are considered the risk free rate, then the increase in required return for large company stocks is added and so on until a risk rate equal to the risk in the subject company is calculated. Again, this is an estimate of the return that will be required by an investor to invest in the company.
Under the discounted cash flow method each years future cash flows are forecast, discounted, present valued and added together to perpetuity. Because perpetuity would be hard to calculate this usually includes a terminal value calculation to address the period between the end of the forecast and perpetuity. This terminal value is added to the value from the discrete years.
Under the capitalization of earnings approach historic cash flows are reviewed and adjusted to reflect likely future cash flows. Then the discount rate is reduced by a long term growth rate to develop a capitalization rate. Finally the next year’s cash flow is divided by the capitalization rate to determine the value.
Please note: this article is a simplified overview, estimating and normalizing cash flows and estimating the discount and capitalization rates quickly becomes quite complex.
Two other major factors may provide a huge swing in value found: determining what interest is being valued and deciding the standard of value
Interest being valued – Often the value of the entire business is being valued. This is the enterprise value which includes both long term interest bearing debt and stock or equity in the capital structure. If the debt is subtracted or otherwise adjusted for the stock or equity value is calculated. Those are two interests. Discounts can be used to adjust for variances between the comparable set and the subject company. More often discounts are used to adjust for differences between majority control owners of a company and minority non-control shares in private companies.
Minority non-control shareholders are shareholders who cannot directly influence company policy and procedures. Because these shareholders are “along for the ride” there tends to be no market to sell these shares. Therefore under a fair market value standard of value (essentially a transaction price) they have far less value than the majority or control shareholders stock. Where a lack of control minority interest is being valued discounts for lack of control and discounts for lack of marketability (DLOM) are estimated and used to reduce the enterprise value found. Stock options, debt, convertible debt are all interests in businesses that can also be valued. Finally goodwill and personal goodwill are intangible interests that may be valued. Valuing each interest involves additional methods and comparisons.
Standard of Value – this is shorthand for who is the buyer and who is the seller. For instance a race car will have very different values to a family looking for a safe car and a race car driver.
Fair Market Value – “The amount at which the property would change hands between a willing buyer and willing seller, when the former is not under any compulsion to buy, and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.” Rev. Ruling 59-60.
Basically this is a typical buyer and a typical seller making a market. The buyer and seller are hypothetical not the actual parties.
Fair Value – is the same as the fair market value of 100% equity ownership in the enterprise divided prorata based on percentage ownership. There are no discounts for minority interest or discounts for lack of marketability for lack of control shareholders. This is frequently used in state statutes to protect minority shareholders.
Synergistic Value – This is the value to a buyer where the buyer can make more money from the acquired company than the acquired company could on its own. For instance two delivery companies with half empty trucks going on the same routes. Surely if one acquired the other the successor would be more efficient and profitable. Therefore the target company can be worth more to the synergistic buyer than other buyers.
Investment Value – this is a market value where the buyer and seller are known and the valuator attempts to use actual revenues and expenses from the two companies. Remember fair market value is NOT the actual buyer and seller but a representative typical buyer and seller.
To Summarize
The subject company or company being valued future cash flows are estimated and is compared to a comparison set to determine value.
Under the asset method it is the cumulative total asset value less total liability value.
Under the market method it is comparing market sale comparables to the subject company.
Under the income method it is comparing all investment opportunities to the subject company.
These methods are used to determine the enterprise value. This enterprise value will be influenced by the standard of value or definition of who the buyer and seller are. Finally discounts may be applied for minority or other interests. The results are an indication of value.
Greg Caruso J.D., C.P.A., C.V.A. is the author of “The Art of Business Valuations: Accurately Valuing a Small Business” (to be published by Wiley in late 2020), an easy to understand yet technical guide about on valuing small (under $10 million revenues) and very small (under $5 million revenues) businesses. In addition, sample reports, checklists and working Excel files of many calculations are provided as resources
