Every business owner has at some time wished for some single correct formula for calculation of “true” business value. The beauty of a free market economy (and the artistry of great merger and acquisition success) is that value moves and lives and breathes. Free market value is almost as difficult to analyze intelligently as the tax code.
Nonetheless, in real life, business sellers and investor buyers each have to start someplace in quantifying value expectations.
There are dozens, possibly even hundreds, of formula approaches possible, but most sellers go at the valuation process far more simply than buyers. The most common approaches by the seller, in ascending order of realistic viability are:
a.) The seller asks himself “How much do I need to live comfortably for the rest of my days?” (Absolutely irrelevant to any buyer) b.) The seller seeks published information on pricing and calculates price relative to aggregate sales volume, to estimate value as a multiple of sales volume. (Usually wrong, and relevant only if all possible buyers can produce uniform profit percentage returns on a given volume), or c.) The seller uses some multiple of earnings which he has heard about as a norm for his business (simplistic, but by far the closest of these three to likely reality).
Buyers, on the other hand, generally go through a far more complex analysis. In attempting to discuss a professional buyer’s eye view to the question of valuation, we’ll group the main concepts of buyer pricing issues into four segments.
Mechanical Earnings Multiple Calculations Buyers almost inevitably start any analysis with some variation of an earnings multiple formula. Before applying their earnings multiple, they first recast the financial statements of the seller, to try to make such statements owner neutral. Any impacts of distorted financial results due to specific seller ownership are carefully removed from the calculation. For example, if the CEO and owner is replaceable for $200,000 in salary, on the open market, but his present salary is $500,000, the buyer adds back $300,000 to earnings.
After measuring what they believe to be a fair performance level of the company, before owner distortions, the buyer then typically applies some rule of thumb multiple to resultant earnings. Rule of thumb multipliers for a typical manufacturer, for example, may range from as low as four to as much as eight times earnings, depending on the business niche. In most specific business sub segments, a vast majority of buyers will think of fairly consistent ranges as normal multiples for valuation in that segment.
The multiple is typically applied to EBIT (earnings before interest or taxes) or to cash flow, usually approximated by EBITDA (earnings before interest, taxes, depreciation, and amortization) less normal capital expenditures.”
The first, the simplest, and the most mechanical element of valuation is done. (A note of caution here, however: Earnings multiples are applicable only if there is a positive earnings level. For companies losing money, the more common starting point in value is somewhere between asset liquidation value and asset book value. For easy turn arounds, value goes up, and for companies in highly troubled markets, or for companies with very severe problems, values drop.)
Buyer Synergy – The next critical element in the buyer calculation- which the seller may never fully know or appreciate- is the buyer’s analysis of synergy. If the buyer is confident that they can dramatically improve their own overall earnings by ownership of the target, they can afford to pay more.
Synergy may come from simple cross sale of capabilities to a greater breadth of customers (buyer to seller and vice versa). It may come from ability to reduce overhead in the combination. It may come from dozens of possible benefits of combination. Regardless of specific source or reason, the buyer has value in synergy when he knows that he can add more to his overall performance than just the simple addition of combining his earnings with those of the seller.
Capital Requirements – Next, the buyer must factor in some consideration of possible cash required to make the purchase. If the prospective target has no potential for bank financing, which would preferably be used to cover a part of the purchase price, then the buyer will need a greater capital investment up front. Less cash will be accessible for other needs. A greater investment will be at risk. Alternatively, if the company to be purchased can immediately borrow part of the purchase price on its own stand-alone merit, the buyer may reduce up front cost and risk, which makes the transaction more desirable.
Buyers need to calculate rate of return on invested capital. They need to consider how long their investment will be tied up before pay back. They need to consider opportunity cost, in comparison to alternative uses for their investable cash.
One common mechanism for reducing up front cash required when bank debt is not available is a longer-term pay out to the seller. Such delayed payment may be either as simple as a delayed note over a long term, or as complete as a bonus payment to the seller contingent upon performance results. While not a favorite mechanism from the seller’s view (and thus a potentially dangerous approach in a bid situation), this can be at times the only viable way to bridge a gap between seller desires and buyer risk tolerance, especially if the seller is a company with inconsistent results or disproportionately low borrowing capabilities.
Market Impact – The last major element to the typical range of buyer considerations required is the estimate of market impact. The buyer must somehow estimate the competitive pricing likely by other potential buyers. If the seller has no other candidates, the buyer has an ideal lack of competition, and can afford to some extent to be slow in increasing price. This is not to suggest a classic “low-ball” bid. It doesn’t pay to get far under normative pricing, because even the seller who wasn’t actually marketing his company will inevitably begin checking around for alternatives. However, in the case of minimum competition, careful and conservative pricing is probably very appropriate.
If the seller is known to be talking to multiple buyers, the buyer must be more careful to at least place themselves in the running as a clear and earnest contender, with a reasonably aggressive initial bid. If there are multiple good strategic buyers, pricing is likely to be pushed upward for synergy. For example, if a company is producing $10 million in annual earnings as a stand alone, but there are five buyers for whom it could produce $20 million per year, the pricing will likely land at a multiple on earnings between the two levels. The winning buyer will likely be the one who shares the greatest portion of the extra value with the seller by increasing his offered price.
Naturally, these are only primers to understanding the professional buyer’s view to business value. Every situation has individual idiosyncrasies, and every buyer may have a different profile and a different fit. The best teacher of value is competitive experience.
As you go forward in exploring acquisition possibilities we wish you well, as one of our clients put it recently in a post-closing celebration toast, “May our acquisitions today pay dividends tomorrow.”