HOUSTON BUSINESS REVIEW

TUTORIAL ON SELLING YOUR BUSINESS: “Valuation – What’s My Business Worth” Part II
By Ralph Fain

Ralph Fain is a principal in the brokerage firm, R/Fain Group. Mr. Fain also has over 20 years of broad business experience with Fortune 500 companies. R/ Fain Group is a professional business brokerage firm which confidentially represents the interests of various sellers and buyers. Each week Mr. Fain will give tips on Business Brokering, and how to sell your business.

In past articles we have discussed some of the key factors which can affect the value of your business – these incorporate such issues as having a good financial track record, having adequate/valid documentation, having basic systems/procedures in place, tangible factors (e.g., clean modern facility, well maintained equipment, etc), intangible factors (business reputation, customer relationships, etc), having a solid management team/organizational structure in place, value of assets, etc. – (for more information regarding this topic, reference my previous article “Enhancing Value – Summary”).

Our last article introduced the reader to several different methodologies for the valuation of businesses – (1) multiple of earnings/market comparison valuation, (2) discounted cash flow/ income methodology, and (3) asset/cost valuation. This article summarizes how business values are calculated using the above methodologies and which types of businesses (in general) are suitable for which types of valuations.

The asset methodology utilizes a combination of stated “book value” of assets and the replacement costs of these assets as its primary indicators of value. This approach assumes a buyer would pay no more for an asset than its replacement cost and also allows for adjustments for factors such as obsolescence. This method is useful in calculating the fair market value of a company’s “hard” assets. An asset/cost valuation may be utilized for manufacturing or other stable companies with considerable tangible or “hard” assets (property, plant and equipment).

The discounted cash flow/income method estimates the present value of future cash flows forecasted to be generated by the business. These cash flows are estimated for a period of time (generally 5 – 10 years) and then discounted using an appropriate rate (frequently, IRR – internal rate of return); note that near term cash flows have a higher present value than do long term cash flows in this calculation. This methodology is appropriate for mature, steady, cash generating companies with consistent historical financial results. This type of valuation can be comprehensive and complicated (as are most valuation methods) due to its requiring an analysis of all fundamental factors impacting revenues/ expenses and capital expenditures.

The multiple of earnings/market comparability method values companies based on some specific type of multiple and also compares this value to similar type companies (“comparables” or “comps”) which have recently transacted. The multiples utilized can be multiples of earnings (EBIT, EBITDA), multiples of cash flow (SDE, SDCF), or even price/revenue multiples. In certain cases, earnings can be adjusted for unusual, one-of-a-kind expenditures to arrive at some standardized or normal earnings figure for the company. In general, the business is then evaluated in comparison to industry standards and to other companies similar in type which have been recently sold/purchased. A multiple (or rather series of multiples) are developed and the value of the company is thus determined.

Because this method appears deceptively simple, I have come into contact with many individuals who consider themselves “authorities” on the pricing of businesses – they are “absolutely certain” they know if a business is over or under priced. They are completely confident in their opinion until asked as to what earnings figure was used in their comparison calculations (was it EBIT, EBITDA, SDE, SDCF, etc) and they are completely at a loss when asked as to what was included in their pricing comparisons as determined by the multiples (was inventory included? accounts receivable? cash? FF&E? real estate? were any liabilities included? etc) .

As mentioned earlier in this article, business valuation methodologies are complex and comprehensive and because they require much skill and expertise to perform, they are best left to professionals. You should beware of so called industry “rules of thumb” as these formulas tend to be general in nature and reliance upon same could prove costly. As a seller (particularly for mid-sized companies), you should request an evaluation from a professional business appraiser as this gives you a starting point from which to begin negotiations with a prospective buyer. In the end, however, the price arrived at will be fair market value (FMV) and will be determined as a result of negotiations between a willing buyer and a willing seller.

See you next week in this same space for our next article. As always, should you have any questions or require additional information please feel free to contact the R/ Fain Group at 832-646-0832 or via our web site.