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    Business valuation basics

    Feature, Management | October 1, 2011 | By:

    Merger, purchase, sale or expansion? The first step is knowing how to establish the value of a business.

    Every owner could benefit from establishing the value of his or her business, but if there are plans to sell, buy, merge or expand, it’s essential to have a clear understanding of value before proceeding. The person who is considering acquiring a business (acquirer) will need information about the business from two different standpoints: “black and white,” which is a combination of numbers used to create a valuation range that defines both the high side and low side of the business valuation, and “color,” which will determine if a particular business will ultimately be valued on the high end or the low end of the ranges.

    One size does not fit all

    A business owner may call a consultant with some data, such as revenue, net income, cash flow and asset value, wanting a business valuation over the phone. Business owners sometimes want to take a formula based on revenue, cash flow or asset value, apply it to their business and then compute a value. (In fact, owners generally want to take their “favorite” valuation formula that gives them the best overall valuation.) This simply does not work. There is no “one size fits all” formula. The reality is that all the formulas work together to determine the ultimate value.

    For example, a business owner calls and says he heard that businesses in his industry are selling at one times revenue. Business A is doing $1 million of revenue, has $500,000 in assets and has $100,000 in cash flow. Business B is doing $1 million in revenue, has $700,000 in assets and $250,000 in cash flow. Do you really think that Business A and Business B have the same value just because they are doing the same amount of revenue? Again, all the factors have to be looked at before determining a true market valuation.

    “Black and white” factors

    The three most important “black and white” factors that determine value are revenues, cash flow and asset value. Financial data for the business to be acquired (called the “target”) needs to include the last three years’ fiscal ends—for example, the years ended Dec. 31, 2008, 2009 and 2010. The current year data compared to the prior year data is also important: for example, the nine months ended Sept. 30, 2011, and the nine months ended Sept. 30, 2010. Using that data, a trailing 12 months (TTM) can be constructed for the period Oct. 1, 2010, to Sept. 30, 2011. Generally, banks, investors or an acquirer do not like to base valuations on data more than 60 days old. The older data is more for point of reference and trend analysis.

    Revenues. The key is determining the quality and consistency of the target’s revenue stream. What are the trends, upward or downward? How do these trends compare to that of the industry? Is there a customer concentration issue? (For example, do a handful of customers account for the bulk of the revenue?)

    Acquirers also like to see a broad customer base. Are there any large, one-time-only orders? A damaging hurricane, for example, can cause a spike in business for a company providing materials needed in response to a disaster, but that business is not likely to be sustained. Can the customer base be counted on for repeat business? Are there any long-term contracts or contracts that are about to expire? Are there different segments within the revenues that are trending upward or downward? What is the gross margin on revenues and on each revenue stream? Are revenues increasing but gross margins decreasing, or vice versa?

    Cash Flow. Many of the same factors that apply to revenues apply to cash flow. The cash flow of the target business is generally computed using EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). To compute EBITDA, take the target company’s net income and add to it four expense items: interest, income tax, depreciation and amortization.

    Usually with cash flow, the acquirers start to analyze what the target business would look like under their direction. How do the cash flow margins (as a percentage of revenue) for the target business look compared to that of the cash flow of the acquirer? An acquirer may feel that he or she can improve cash flow—or that it would be hard to continue the cash flow of the acquired business because it is so much better than that of the acquirer.

    These questions can have implications on both the “black and white” and the “color” analyses. For example, acquirers generally will not pay for synergies they may have once the business is acquired (improved cash flow), but that may influence the valuation upward within the black and white ranges of what they may pay. Conversely, if they do not feel they can operate the target business as profitably as the former owners, they most assuredly won’t pay as much for it.

    Assets. A good asset listing of the business is needed to properly analyze the assets. Usually real estate is not included in the transaction (see “The real estate question”) and is excluded for the purposes of the valuation.

    In a manufacturing operation, there are two primary types of assets in the business acquisition: operating assets and inventory assets. Operating assets are the infrastructure of the target business and include machinery and equipment, computers, office equipment, and warehouse and transportation equipment. In all cases, the target company should have a good listing of each of these categories including make, model, serial number, acquisition date, acquisition cost and net book value.

    Using this list, a reasonable and defensible fair market value should be determined; this can be done on an item-by-item basis via an equipment appraisal, or sometimes there are good industry “rules of thumb” based on acquisition dates and acquisition costs. Acquirers will want to see that the target company has made continued investments in infrastructure consistent with industry standards to keep the equipment current and to minimize repairs and maintenance expenses. Any perceived “deferred investment” or any investments needed by the acquirer to get the equipment up-to-date or to standard will be deducted from the valuation.

    Inventory assets are raw materials, work-in-process and finished goods. Is all the inventory current and salable? Are the inventories in quantities consistent with current demand and consistent with past practices? Any excess or obsolete inventory will be discounted dramatically or disregarded. It will need to be determined if the carrying cost of inventory is indicative of the true market value of the inventory.

    “Color” factors

    Important additional factors should be carefully considered, beyond the numbers (or black and white) side of the information gathered. Among the color factors are:

    • What are the strategic implications of acquiring this business? Will it open up a new geographic region, a new product line or a new set of customers that will provide synergies for the acquirer?
    • Are other synergies in play for the acquirer, such as cost savings through consolidation of functions, consolidation of facilities or a new technology acquired?
    • What do the employees of the business bring to the table? Exceptional or marginal management? Operations, engineering and sales talent? Who is willing to stay on? Who does the acquirer risk losing?
    • What are the trends of the business, up or down? Falling revenue or profit creates uncertainty, and uncertainty drives transaction prices downward. Upward trending revenues and profits, if sustainable, drive prices toward the upper end of the range.

    Valuing a business can be a complex matter—in fact, something new can be learned from every transaction. These basic points offer a way to get started with the process—and hopefully keep moving in the right direction.

    Gary Stansberry is principal of The Stansberry Firm LLC and specializes in business sales, fair market business valuations and positioning businesses to increase their value.

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