by Steve Goodman
CPA, MBA – President & Chief Executive Officer
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Most business owners conduct their business with little in-depth knowledge about the value of their company. Whether the company is worth $15 million or $26 million makes little difference in how one manages a business on a day to day basis. While one can argue it should be relevant in long term business planning, most business owners think in terms of marketing, capacity, staffing, and capital needs. Business valuation is a fuzzy concept that is not particularly relevant in the normal operation of a privately held business.
Events happen in a person’s lifetime that makes business valuation extremely relevant. People get divorced. People start thinking about business succession, estate planning, charitable causes, and other events that require an estimate of the worth of a business. Sometimes, the one asking for a business valuation is an attorney or the Internal Revenue Service.
A business valuation is an appraisal of a business. There are certain things that are easy to appraise. Your 2016 Chevy Tahoe is relatively easy to value. Mileage, condition, location, and comparables are all one needs. Yet even after all these factors are known, there are multiple answers. There is a price for a private sale, a trade-in value, a dealer resale, and an auction price – four prices for the same Tahoe based on who is buying.
Appraising a business is far more complex. There are many more factors to consider beyond mileage, condition, etc. There are thousands of other privately held businesses that can serve as comparables, but with the exception of a few private sales that made the news, that information is not available. The universe of public companies offers considerably more detail, but there are critical differences between public and private companies.
A business valuation specialist is a person trained to look at a business, look at the information available in the public realm, and make some critical adjustments that allow him/her to build a case for putting a price tag on the private business. Many valuation analysts have completed formal training offered by a certification granting organization. As a good rule of thumb, if they can show credibility with the IRS and/or the court system, they qualify to offer a written valuation.
The Valuation Process – Overview
There are multiple methodologies to value a business. All involve math, assumptions, and estimates. There are formulas, developed over many decades, to determine the value of a business in which almost all information is known. That is, investment firms, sophisticated investors, bankers, and company M&A departments have been working with these formulas for many decades. As financial journals and researchers refine the methodologies, the industry adopts updates.
The challenges in using public company valuation formulas to value a private company are that while public and private company may be direct competitors, they think and act differently. These differences present challenges in valuing a business. Differences typically, but not always, include the following:
- The public company makes business decisions with an eye towards profit maximization. The private company makes the same decisions with a focus on tax minimization and/or cash preservation.
- The public company, if creditworthy, has access to the debt markets, the ability to sell stock, bank borrowings, and private lenders using stock as collateral. A private company can generally only borrow from a commercial bank.
- The public company tends to be bigger, in part, because it has access to more capital resources.
- The public company has a Board of Directors. The Board insists the company focus on management succession, corporate planning, best practices in managing and training people, etc. Private companies tend to run lean with family sometimes deeply embedded in the organization regardless of talent, skills, or competency.
- Public companies are under constant scrutiny. Hundreds to millions of investors make an independent valuation of the company’s valuation every trading day. Private company valuations may be determined once every 5 to 10 years.
- Public companies must file critical information required by investors. Private companies should have the same information available to give to a valuation analyst, though it may not be current or available in writing.
Business valuation is part science and part art. There is often no right answer. There are, however, wrong answers. If the IRS rejects a valuation, that is a wrong answer. Their acceptance does not make it a right answer, just an acceptable answer. Similarly, if the judge in your divorce or minority shareholder lawsuit rules against your valuation, then it is wrong. A positive ruling does not infer an accurate valuation, just an acceptable valuation.
The valuation process begins with an understanding of the subject business. There are multiple ways to value a business. Multiple methodologies typically yield a range of estimates. Some businesses dictate that certain techniques be given greater consideration. This is particularly true when one is engaged in a heavy capital asset business, like a refinery, mine, or very expensive machinery.
Companies with high barriers to competition through patents may be valued largely on the basis of the patent’s value and remaining life. For many other businesses, there are multiple means to estimate their value.
As a rule, the first step in valuing a business requires recasting the company’s income statement, balance sheet, and cash flow statements to reflect how they would look if they were a public company. Private companies make decisions based on cash preservation and tax minimization, principally because they have limited sources of external capital. Public companies do not have the same constraints. They may employ different strategies given similar business conditions.
Private business owners also tend to take a more liberal approach to mix business expenses with personal expenses. These ‘owners’ benefit’ costs require removal from the income statement. Private businesses may lease equipment whereas a public business might buy it. Certainly, there are tax differences associated with a privately held LLC or S Corp versus a publicly held C Corp.
After revamping the financial statements, the analyst will use one, and often more than one, methodologies to value the business as if it were a public company. These methodologies are discussed later in this article. By virtue of the recasting of the financial statements, the selection of appropriate methodologies, and the use of comparables to develop valuation, the analyst has created three areas of possible challenge. But the greatest area of potential challenge is the final area.
Our analyst has looked at the privately held company, analyzed the business, evaluated the financial statements, made some assumptions about what the company would look like if operated as a public company, identified valuation methodologies appropriate for the business and identified comparable companies. These comparable company characteristics include debt/equity ratio, P/E ratio, market beta, and many others.
Our analyst has introduced multiple assumptions into the process that may be challenged by an attorney, the IRS, or others. Assuming the analyst’s work is supportable, he/she has identified value for the business as if it was a public company as of the completion of this step.
There are is one more step. The business is not a public company. It is a privately held company. That makes all the difference depending upon who is looking at the business. So, adjustments need to be made. Note that valuation models all assume that if two companies are comparable, but one is riskier than the other, the riskier company will have a lower market valuation.
- All else being equal, an average private company is generally worth 20% to 30% less than its publicly held twin. The case can be made for an even greater discount in some circumstances, but as a rule of thumb, 20% to 30% is common. This reflects an owner’s lack of liquidity plus other factors.
- When valuing the equity of the privately owned company, one must take the ability to make decisions into account. A minority shareholder may have no ability to influence things like management salaries, dividend policy, business strategy, etc. This warrants an additional significant discount.
- Non-voting shares reflect the same lack of influence that a minority shareholder has but to a greater extent.
- As a rule, the bigger the company, the greater its ability to weather financially challenging times. There are many counterexamples, but the weight of the evidence shows that size is a benefit. A smaller company is riskier than a larger company, all else being equal. If the company under consideration is smaller than the comparables, its valuation needs to be adjusted for size.
- Management talent and depth is a highly subjective area. The base assumption is that private companies run leaner and more disorganized in terms of management succession, planning, and training. This may not be relevant in all cases.
- Smaller companies tend to rely more heavily on one line of business than larger companies. All else being equal, a company with multiple product lines is less risky than a one product company.
There are three methodologies commonly used for most company valuations. They include the following:
- Comparable Company Analysis
- Comparable Transaction Analysis
- Discounted Cash Flow
Lesser used valuation methodologies include Break-Up Analysis, Asset Valuation, Replacement Cost Analysis, and Leveraged Buyout Analysis.
Comparable Company Analysis
Computers and databases make it possible to scan the universe of companies and their financial filings to find companies that best match the target company’s business and financial characteristics. Once a highly time-consuming process, modern technology has greatly simplified the search portion of this process.
In Step #1
The analyst recasts the private company financials to reflect on how they might look if the company operated as a public company. This becomes the starting point for a data search. The analyst searches for companies that match the industry, gross sales, capital structure, and growth rate, among other key factors. An initial search may result in very few comparable companies.
With each search, the analysts will open the ranges of acceptable comparables until he/she has a ‘reasonable’ sample size. The analyst must then look at each comparable to understand that there are no special circumstances that would skew their valuation.
After culling or adjusting the list to reflect unique circumstances, the analysis is ready to compare the means and variances of the comparable group versus the target company.
In Step #2
the analyst will value the company as if it were a public company based on the comparables. Given many comparables, the analyst may use regression analysis to forecast enterprise value based on key characteristics. A smaller sample employing multiple adjustments may yield a range estimate of valuations.
The third step involves scorecard. The analysts will look at the many characteristics that typically differentiate a public company from a privately held company. Mindful of discounts (or premiums) that have passed muster with the IRS and courts in the past, the analyst will begin this most subjective phase of the analysis. Relative company size, management talent, business focus, reliance on a single supplier, customer, or distribution channel, and several more aspects of the business require evaluation.
The analyst will score the company on each aspect granting or deducting points/percentages for each significant difference. The final product is often a valuation range rather than a point estimate. This range allows the estate planner, divorce attorney, business broker, or other negotiating party to understand the supportable high and low valuations they may consider.
Comparable Transaction Analysis
This analysis is similar to the comparable company analysis with a few differences. The company analysis looks at companies in their steady state. They are actively traded as ongoing companies. In the transaction analysis case, the analyst is looking for buy-out situations that define how much a comparable is worth when acquired. Most public companies sell at a premium to their trading valuation. A company that traded on Monday at $35/share may receive a buyout at $42/share on Tuesday. The same company, doing the same thing on a daily basis, is suddenly worth 20% more.
Before one uses comparable transaction analysis, one must assume that the basis for the valuation is a sale – a real sale. Selling the business to one’s children for tax purposes is not the same as a profit-maximizing sale to a third party. The soon to be ex’s attorney’s assertion that your CPG firm is worth what Proctor and Gamble might pay for it is also not relevant. P&G has yet to come calling and is unlikely to ever do so. But if a sale to a third party is under discussion, this analysis is relevant.
The problem is that the number of quality comparables based on transactions is far smaller than just comparable companies. Of the 10 companies that might be quality comparables, at best one or two may have been bought out. If one limits the buy-out to the last 5 years, the number of comparables declines even more. One has to widen the range of what defines a comparable considerably to generate data.
Some of the data may involve the acquisition of other privately held businesses. Much of the relevant data surrounding the transaction will be unpublished. Some may be available in an SEC filing. It can be a time consuming and arduous task to build a small database of comparables. Once assembled, however, the analysis process is much the same as the comparable company analysis.
Discounted Cash Flow Analysis (DCF)
DCF analysis is used in many applications. It is easy to explain, mathematical, and totally logical. It is also subject to many assumptions and easily manipulated to provide the desired answer. In short, it takes an experienced analyst to perform and another experienced analyst to interpret the results of this analysis.
Common business precepts dictate that an investment is worth the net present value of the cash flows from the investment. In simple terms, Company XYZ is looking to buy a machine for $100.The machine results in a net reduction in expenses of $14/year. Given a few assumptions, we can determine whether XYZ should or should not buy the machine? It is no different when considering the value of a business. Company XYZ is considering the purchase of the Company
ABC. Company XYZ wants to know how much value ABC brings to XYZ. The numbers that go into the calculation can require considerable study and analysis. But the concept is simple. There is a cash outflow to buy ABC on Day 1. By the end of year 1, ABC will have produce CFY1 in cash flow to the parent company. Year 2 will yield CFY2 and so on. We take all those cash flows, discount them by the cost of money to buy ABC, and sum them up. If the sum is worth more than ABC cost to buy, it’s a good deal.
There are a few additional steps that really complicate the computation. Typically, we carry the annual cash flow analysis out for 5 to 7 years. The longer we carry this calculation out, the fuzzier the reliability on which the cash flow forecast was based. What happens after year 5? We have a choice. We can assume the business is sold to a 3rd party or we can assume we own it forever.
If we assume we sell it, we have the small detail of trying to estimate what the business is worth five years from now. XYZ had enough challenge trying to do a comparable company analysis or comparable transaction analysis using current data. Now they face the challenge of valuing ABC five years from now. Alternatively, XYZ assumes they will own ABC forever. They take the cash flow from Year 5 and project its net present value as if it continued in perpetuity.
The DCF formula, using the terminal value option, is as follows:
Using the DCF formula, let’s test the hypothesis that the machine is worth the price of $100.
If we assume the numbers are correct, the machine is not worth $100. It is worth roughly $95.
Note that the formula relies heavily on two assumptions – the discount rate (known as the weighted cost of capital or WACC) and the terminal value of the project.
WACC is an estimate of the after-tax value of the company’s capital structure expressed in percentages. The mathematical formula is not complicated, but the development of this number can be very complex, especially for a privately held business. A modest change in WACC can mean a significant change in the DCF.
WACC = (KDebt*WDebt) + (KEquity*WEquity)
Where: KDebt is the after-tax cost of debt
WDebt is the percentage of debt in the company capital structure
KEquity is the cost of equity (there is no tax effect on equity)
WEquity is the percentage of equity in the company cap. Structure
(Interested readers are advised to see “Estimating WACC for Private Company Valuation: A Tutorial” in the Business Succession section of this website for detail on how WACC is computed.)
The terminal value of the investment is the other major factor. This number is particularly critical when one is looking at a fast-growth company.
Before moving on to other valuation methodologies, a brief discussion of cash flow is in order. When looking at acquiring a business, the relevant cash flow definition is Free Cash Flow (FCF). Free Cash Flow is cash flow after required reinvestments and mandated payments such as preferred stock dividends. Consider a growing chain of retail stores. The business grows by two metrics – increasing sales per square foot of retail space and new stores.
Ignoring store remodels for the sake of the discussion, if the company stopped investing in its store network, it would grow solely on the basis of higher product prices due to inflation and increased store sales as more people found the store and liked the product mix. Companies interested in growth take the opportunity to expand their operations through new locations. A 40 store network may have a goal of 6 to 8 new locations per year. These cost money and that money reduces cash flows. FCF accounts for these mission-critical capital investments.
Break-Up Analysis – This methodology is used when companies do two or more things that can be segregated and evaluated separately. Company XYZ produces widgets in a factory and has 30 retail outlets that sell widgets. These two business units can be valued separately. The company is the sum of the parts. Several large companies, including General Electric and United Technologies, are often the subject of valuation based on the sum of their parts when broken up.
A company that is based on a major asset is a prime candidate for this analysis methodology. A company that operates amusements parks may be valued on the basis of its rides, amusements, and most importantly, its real estate. When a company’s assets are worth more than its value as an ongoing business, it becomes a candidate for purchase and disassembly.
Sometimes a company is worth what it would cost to replace its tangible and intangible assets. A Miami-based meal plan company was purchased by an acquirer in 2014 for a price that probably reflected a 100% premium over the business’s replacement cost. The acquirer paid $14 million in equity and assumed roughly $4 million in debt for a business they could have reproduced for roughly $8 to $9 million. A replacement cost analysis could have provided this information.
Leverage Buyout Analysis (LBO)
in the 1980s and 1990s, LBOs were the rage on Wall Street. Management was buying their companies, often with the help of a private equity firm. The management teams would replace the company’s customary 30/70 debt/equity capital structure with a 95/5 debt/equity structure. The primary concern was the company’s ability to generate sufficient cash flow to stay current with the debt payments as they came due. In this methodology, one measures free cash flow and estimates how much debt the company’s cash flow will support.
This article offers an introduction to business valuation. It is a very complex subject involving not only the business to be valued but also the perspective of the person for whom the valuation is made. The same business can have dozens of valuations, all shown to be supportable in a court of law, depending upon who is looking at the business and for what purpose. The range from high to low can be 2:1 in some instances.
Hiring a professional to value a business can be an expensive proposition. But the cost of an improperly performed valuation can be far greater. Business owners should be aware of the complexity involved in determining a value for their business. With proper planning, it may be something that a business owner need only pay for once.
CPA, MBA – President & Chief Executive Officer
About Steve Goodman
For more than 30 years, Steven has provided insightful solutions to the challenges of business succession, wealth preservation and charitable planning, focusing on the needs of owners of closely held businesses and high net worth individuals.
He's been featured in the New York Times and is an accomplished speaker and has presented over the years to many organizations and professional groups on efficient business succession, estate planning issues and tax strategies. Steven is a CPA who was vice president of the Trust and Investment Division of JP Morgan Chase and a supervisor for KPMG Peat Marwick, and holds an MBA from Fordham University.