Do you find business valuation a testing task? Find out more about an alternative approach to testing a business valuation for a better practice.
By Leonard M. Friedman, Business Valuator
Many attorneys come up to me and ask how they can better understand the process and conclusions drawn in the valuation of a business. There are many articles that have been written on the subject of valuation and still many attorneys seek clarification. This is understandable since traditional valuation methods are very technical and confusing to the layperson; however, the complexity is necessary because of where appraisers get their data from and the way they are properly taught to apply it. Many authors try to simplify the explanations but still have difficulty again because the traditional methods of appraisal are complex but albeit necessary.
Quite frankly I see the same issues- I can explain valuation to some people and they get it, and some people continue to have difficulty understanding it. Does a person really have to be mathematically oriented to understand the simplest aspects of the valuation? I would like to believe they do not. In this article, however, I am going to approach the explanation of testing a valuation in a different way, and I would love to hear from readers as to whether this alternative approach makes more sense to them. It is more apt to give the attorney a better smell test rather than teaching them the intricacies of the valuation process.
First, the Same Old Stuff:
Keep in mind that when investors put their hard-earned or guaranteed borrowed money in a business they want a rate of return on their investment commensurate with the risks associated with the investment. For instance, a risk-free rate of return for a twenty-year U.S. Treasury investment is currently 4.0. Going up the risk ladder, corporate long term bonds are at 6.5%, the S&P 500 long-range stock outlook, as commensurate with history, is approximately 10-12%, and small public company stocks range from 14% to 20%. Therefore what should the rate of return be for a small closely held (likely micro-managed) business? The answer is most definitely between the mid-range of small-cap stocks and a number that is quite a bit larger. The after corporate-level tax rate of return for small businesses generally range, with exceptions, from 16% to 26% depending on the quality of the company and a host of many other factors. Again, this is not the rate of capitalization but the rate of return. The capitalization rate (which is the earnings divisor) equals the rate of return less a long term growth rate. And finally, the inverse of a capitalization rate is a multiple of earnings or a price/earnings ratio.
Some Different Terms and Definitions
- EBITDA-Earnings before interest, taxes, depreciation and amortization- Simply taking adjusted income and adding back the various items to get EBITDA. This is a common measure of income by which Business Brokers will multiply by a number to estimate the potential value of a company they are selling
- Owners Discretionary Income (ODI) –Another commonly used business brokerage term that equals the adjusted income from the business and adding back owners compensation and perquisites as well as interest, depreciation and amortization.. This is the total available earnings to an owner including his/her salary. Alternatively, ODI is simply EBITDA plus owners compensation.
An Alternative Approach of Testing a Business Valuation: Thinking Like a Business Broker
Our accounting and consulting practice has a business brokerage of which we generally act as a buyer’s agent. In addition, I do perform the valuation analyses and determine the adjusted income derived from the businesses. Of course, when a person is selling their business they are much more forthcoming about the “perqs” they take from the business or the amount of income they do not report than what we encounter in a divorce or other litigation situation. The glass is half full vs. the glass is half empty.
What I love about business brokers are that their approach to estimating value is so simplistic. However, when used with some common sense, their simplistic approach actually converts to values that business appraisers should generally approximate using more sophisticated approaches. Because most small business brokers are more sales-oriented and lack the formal training of titled business appraisers, they will tend to put the estimated values of businesses in their simplest form at multiples of adjusted EBITDA or ODI (As defined earlier). This is something that the majority of non-appraisal professionals should be able to comprehend.
Business brokers use the EBITDA multiple as if it were the gospel. The goals of the broker is to sell the closely held “bricks and mortar” or non-high tech types of small businesses for a multiple of between 2.5 and 8 times EBITDA with the central tendency being in the 3 to 5 times range. “Bricks and mortar” business means a low technology service business such as an engineering firm or a low technology manufacturing firm such as a custom metal fabricator or food manufacturer or a wholesaler or retailer of common or custom goods. This is as opposed to a technology-driven company that owns sophisticated intellectual property such as software or biotechnology. The technology-driven companies, especially ones that are new or that have not reached a profitable status, are rarely valued using the business broker approach.
Brokers less commonly but (often enough) use the multiple of Owners Discretionary Income (ODI) when estimating the asking price for a business for smaller businesses. This multiple tends to be between 1 and 4 times with the central tendency being 1.5 to 3.5 times. You see this measurement in Rule of Thumb books just as often as you see valuation multiples of revenues and, quite frankly it is an easier measurement than the multiple of EBITDA to apply because one does not have to perform a fair salary to owner assessment which is a sticking point with many valuations. However, this methodology is more apt to be used with small businesses that earn ODI under $500,000 because the greater the income, the more the multiple of ODI gets closer to the multiple of EBITDA. This is because the only item that separates the two defined incomes is fair compensation to the owners, and as income gets greater, the less meaningful the fair salary generally becomes, hence this measurement becomes less meaningful when the ODI becomes in excess of $500,000. I have also found the ODI multiple is not generally usable with medical or law practices or other professional businesses where fair compensation varies widely from specialty to specialty.
Why EBITDA or ODI?
Using EBITDA or ODI is an unsophisticated way of estimating a company’s debt-free cash flow which is the true measurement of determining a return on investment. In most instances, it does not truly represent cash flow due to changes in non-cash balance sheet items such as accounts receivable, inventory and accounts payable as well as purchases of capital equipment. Nonetheless, it is still the most commonly used measurement of income for valuation purposes in the business brokerage community.
Applying Multiples of EBITDA
The following illustrates how brokers apply the EBITDA multiples method, (I am sorry, but you will still need to hire a forensic accountant and/or business appraiser to perform most of this task because it will require forensic accounting to adjust the income statement to what is supposed to be the “true income.”) However, you, as a non-valuation person, can better question the results that the appraiser expert concludes with traditional methods by taking his/her numbers and applying a multiple:
Notice how simple it is to simply take the EBITDA or ODI number and multiply that number by a single-digit number rather than dividing it by the all confusing capitalization rate. Also note that the valuation result includes operating balance sheet assets such as the minimal cash needed to operate, accounts receivable, inventory, prepaid expenses, fixed assets, accounts payable and accrued expenses. The resulting value does not include excess cash, investment assets, real estate and other assets and/or liabilities that are not part of normal operations. Interest-bearing debt also need to be subtracted.
Why Subtract Debt?
The EBITDA/ODI multiple is a debt-free number; therefore interest-bearing long term debt is subtracted from the results.
Applying the Conventional Capitalization of Earnings Method
The following illustrates how an appraiser would apply traditional valuation methods to the above company:
The above illustrated that both the EBITDA/ODI multiple goals of the broker and conventional valuation methods can and should come out similar. The conventional methods, however, are considered more concise and the broker method is an estimate.
Usually for growing, profitable small businesses (cash cows) a business broker will ask for five times EBITDA- however this multiple is generally too high for an investment buyer in a smaller business because usually, it will be very difficult for them to realize any cash flow return on their investment for several years. This is because most investment buyers borrow much of the purchase price and have to pay back the debt within 5 to 7 years using after-tax profits thusly draining any available cash flow for a return on their own investment. Hence, an ordinary investment buyer will rarely pay that multiple. The ordinary investment buyer is the hypothetical buyer in the “willing buyer/ willing seller” scenario that one has read about under the fair market value standard.
Low EBITDA Multiples (Below 3)
The following are the characteristics of companies that will be valued at a lower EBITDA multiple:
- Slow or no income or sales growth
- Ageing customer base
- Ageing technology or factory equipment
- Industry losing business to overseas companies
- Heavy reliance on a few customers
- Heavy reliance on a few vendors.
- Very little industry merger and acquisition activity (not always applicable in a litigation setting)
- Accounting Books and Records are inadequate (not applicable in a litigation setting)
- The success of the business is solely tied to the owner ie. professionals (not applicable in a litigation setting)
Poor books and records kill many actual sales deals, but in a litigation setting the non titled spouse or the oppressed shareholder will not likely be penalized because the owner spouse or oppressing owner of the business has poor bookkeeping habits or is playing accounting games.
High EBITDA Multiples (5 or higher)
We work with a few private equity groups that buy controlling interests in businesses, and their purchase price of strong-growing businesses is generally in the 5 to 6 times EBITDA range but many times higher multiples if there is a competition between equity groups bidding on the same company. These groups are well-financed and generally have expertise in the businesses they buy; therefore while they could be considered a sophisticated investment buyer they are many times a synergistic buyer. Many of these groups only buy companies that are greater than say $30 million in sales and have greater than $5 million of EBITDA. Generally, they will buy companies with the following characteristics:
- $5 million EBITDA or better
- Depth of management- they will not buy businesses that are so tied to the selling owner(s) that the customer base or product quality will erode once the owner is gone. The buyer is looking for non-owner management and a sales force that will stay with the company after the purchase.
- Historical strong sales growth with the potential to grow faster with a fresh infusion of cash or other forms of capital.
- Diverse customer base- nothing kills an acquisition deal faster than the dependency of a company on a few customers unless the customers cannot go elsewhere or are legally tied to the product and company.
- Proprietary Products-Products that are exclusive to the company.
- Diverse supplier base- Many wholesalers of goods are reliant on foreign manufacturers to make their products. If the company is relying on one vendor, that is a red flag to the equity groups unless they can make the products themselves- in which case they become a synergistic buyer.
- High gross profit margins and high net profit margins-This speaks for itself.
- Good management of inventory and receivables- The buyers look for the accounts receivables to be collected faster than the industry standard and for inventory to turn over faster than the industry standard. The ability of the company to quickly convert their sales to cash is very valuable.
Why EBIDTA Multiples are Rarely Cited in Valuation Reports?
Unfortunately, there is very little in the way of private company empirical evidence to support EBITDA multiples (other than public company data). The problem is that when a market data collection organization such as Pratt’s Stats or The IBA database or BIZCOMPS receives financial information on the sale of a company, the balance sheet data and the income statement data are not generally adjusted for the items we usually adjust for in a forensic examination. Thus, the only reliable, somewhat consistent data points one gets when looking at these studies is a multiple of revenue and, to a lesser extent, multiples of owners income. Public company data can be gathered if you have a comparable company that is being valued. However, even with owner’s income there can be flawed data because the study may not reflect all of the “perqs” that an owner receives. However, when we perform a market comparable approach in a valuation, usually multiples of owner’s income and multiples of revenues are cited by us and the appropriate multiple is then selected and compared to other methods and/or approaches to value. For larger companies, one can extract public company EBITDA multiples and adjust them to fit the specific valuation subject but this doesn’t generally work for very small companies.
Which EBITDA/ODI to Use
Now is the age-old question of whether one uses an average, weighted average or most current year EBITDA to apply a multiple to for value. The number used should be indicative of the future income stream. If the reader has read any of my articles from the past, they will know that I abhor the blind use of averages or weighted averages especially if a company is in a steady growth cycle or attrition cycle. Do not forget, the true value of a company today is based upon what the expected future income will be. Sometimes it is measured by history or the most current year, and other times it is measured by a present value of future income.
From a historical income perspective, the following are examples of historical EBITDA patterns and what should be used for valuation purposes just from a gut instinct as the measure of value:
Every situation has its own facts and circumstances, however, an appraiser should not use an average unless the historical income trend justifies using it, and the most current year should not be used unless the trend justifies it. For instance in Company number 1, using an average will likely under-value the company because its growth trend clearly reflects that the company is likely not going to be earning the earlier years’ income in the future and is clearly in a growth pattern. Company number 2, on the other hand, has an irregular pattern with up years and down years. Clearly the use of an average would likely be justified. Because of the uncertainty in the Current (2009-2011) economy averages are being used more often.
An Alternative Approach of Testing a Business Valuation: Conclusion
The reader needs to treat this concept of estimating value as more of a “smell test” than a concise valuation methodology. If the valuation an appraiser prepares does not fall within the guidelines of the parameters outlined in this article, then you should question it regardless of what side of the case you are on. Some common reasons could include that the formula did not exceed the company’s book value and the book value ended up to be the concluded value.
Look for the EBITDA or ODI in an appraisal report. You will likely have to use a calculator and add a few numbers, but they should be relatively easy to find if the valuation report is clearly written. Test the valuation results with the multiples suggested in this article. Choose the income that is indicative of the future. Be careful because a complexity may arise if the appraiser’s conclusions include non-operating assets such as real estate, investments and excess cash. Look at the characteristics of a low EBITDA multiple companies versus a high multiple company and compare the subject to that.
Leonard M. Friedman, CPA/ABV CBA serves as the head of Rosenberg Rich Baker Berman and Company’s Valuation Services Department. He has more than 25 years of public accounting experience, including extensive fieldwork in business valuations and forensic accounting.