Common Business Valuation Errors Ignoring Business Growth Rate
Business valuation is a surprisingly complex topic. There are a variety of ways to value a business, and for each valuation methodology there are a variety of issues and assumptions that may impact the value. It is beyond the scope of this document to provide an in-depth description of valuation methodology and broad issues that can impact business value. Rather, this paper will examine a frequent error that many business sellers, buyers, and their advisors make when relying on the most commonly used valuation methods for small to mid-sized businesses. The error: ignoring the impact of the business’ growth rate in the valuation process when using rule-of-thumb or market comparable approaches to value. Before discussing this common error, the following three pages will explain how Rule-of-Thumb and Market Comparable Approaches work.
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Rule-of-Thumb and Market Comparable Approaches to Value Two of the most common, simplistic and flawed valuation methods are the use of rule-ofthumb and simplistic market comparable approaches. Rule-of-Thumb Rules-of-thumb are derived from a set of industry data which has been analyzed to compare average sold business prices to corresponding company financial performance. The resulting rules-of-thumb are then passed on to others who rely on them, usually without accessing or understanding the underlying data that they are based on. For example, someone may have examined a data set of sold businesses in a particular industry and found that the average sale price was $1 million, the average revenue of the sold businesses was $900,000, the average Earnings Before Interest Taxes Depreciation and Amortization (EBITDA) was $200,000, and the average Seller Discretionary Earnings (SDE) was $270,000. The Seller Discretionary Earnings consists of adding back any expensed compensation for one owner to EBITDA. If they divide the average industry sold price by the average revenue, EBITDA, and SDE they will arrive at three different Rule-of-Thumb Multipliers: a revenue multiplier, an EBITDA multiplier, and a SDE multiplier. Average Industry Sold Price
Financial Performance
Rule-of-Thumb Multiplier
$1,000,000
Revenue: $900,000
1.111
$1,000,000
EBITDA: $200,000
5.000
$1,000,000
SDE:
3.704
$270,000 Figure 1
Using this example, the revenue multiplier would be 1.111, the EBITDA multiplier would be 5.000, and the SDE multiplier would be 3.704 (see Figure 1 above). Someone using a Rule-of-Thumb Multiplier would multiply the revenue, EBITDA, or SDE of the business being valued by the appropriate Rule-of-Thumb multiplier. Following is how the Rule-of-Thumb Multipliers derived in Figure 1, would produce estimates of value for XYZ Company, a business with $1.8 million in revenue, $260,000 in EBITDA, and $320,000 in SDE.
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Figure 2 (see below) provides estimates of value for XYZ Company that range from $1,185,280 to $1,999,800. Some people will then average the three estimates of value, while others will use the lowest of the three, rely on just the cash flow multipliers, or attribute a weighting to each estimate of value. Rule-of-Thumb Multiplier
XYZ Company Financial Performance
Estimate of Value
1.111
Revenue: $1,800,000
$1,999,800
5.000
EBITDA:
$260,000
$1,300,000
3.704
SDE:
$320,000
$1,185,280
Figure 2 Market Comparable Approach The primary difference between a market comparable approach and using a rule of thumb, is that the market comparable approach uses documented business sale data as evidence of the multiplier being utilized, whereas the person using a rule-of-thumb will use a multiplier developed by someone else and won’t have the underlying support data. Furthermore, when using a market comparable approach, in addition to looking at documented industry average data, the person estimating value will select, and focus on data for a smaller group of sold businesses that appear to be more similar to the business being valued in terms of what the business does, its size, profitability, date of sale, etc. The business broker or M&A advisor estimating the value of XYZ Company described above may strive to utilize 6-12 sold comparable businesses from the same industry that are fairly close in size and margins to the company being valued, and which sold in the same or a similar economic environment. Unfortunately, it is often difficult to find truly similar sold business comparable data, and as a result there may be comparisons of businesses with significantly different characteristics. Sometimes, so few truly comparable sold businesses can be located, that relying on them to create generalizations of what a business should sell for may not produce a reliable estimate of value. Many people who focus heavily on using a market comparable approach to value argue that what the market has priced businesses at in the past is the best determinant of value. This is problematic because the market for small to mid-size businesses involves a relatively small number of sales of heterogeneous businesses, with limited information available, and that occur over a broad time range. In other words, there isn’t an efficient market for small to mid-size businesses.
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Rule-of-Thumb and Market Comparable Approach to Value Are Fraught With Problems It is easy to see why Rule-of-Thumb and Market Comparable approaches to estimating value are popular: they can be quick and easy to use. Unfortunately, these approaches rely on two problematic assumptions: 1, what others paid for businesses relative to their revenue and cash flow was reasonable; and 2, that the business being valued is truly similar to the sold comparable businesses. There are a variety of characteristics that could vary dramatically from the sold comparable businesses to the business being valued which should impact value but are often ignored in using these approaches to value. Some of these characteristics include, but are not limited to: • • • • • • • • • • • • • • •
Growth rate Size of business Whether Seller Discretionary Earnings exceed a market rate of compensation for an owner Margins Quality of systems Direct competition in the geographic market served Concentration of revenue by client Diversification of revenue by product / service offering Retention rate of clients and/or recurring revenue Retention rate of employees Breadth and depth of management and key employees expected to be retained post-acquisition Years in business Outstanding legal issues Quality of financial statements and records Quality and stability of vendors
Codiligent recognizes that it is problematic to arrive at an estimate of value without taking into consideration the unique risk and reward characteristics of a business. Consequently, Codiligent conducts a thorough analysis of each client’s business and utilizes a more comprehensive approach to valuation. In the remainder of this paper, just one of the above-mentioned characteristics that impact value will be explored in greater depth: the growth rate.
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How does a business’ growth rate impact value? When someone buys a business, just like with any other investment, the buyer wants to achieve a future return on investment that is commensurate with the risk factors associated with that investment. If all other characteristics are equal, should a business with a higher expected growth rate be worth more? Let’s examine this in a very simple way. Assume there are two businesses in the same industry with similar risk characteristics. Last year, each had $5 million in revenue, and $1 million in EBITDA, but Business A had an expected annual growth rate of 10% over the next 5 years, whereas Business B had an expected annual growth rate of 5% during the same time frame. Let’s assume that a Market Comparable Approach to Value indicates that an appropriate EBITDA multiplier is 4.75, resulting in both businesses having an estimated value of $4.75 million. Assuming that EBITDA margins remained constant and all other things are equal except for the growth rates of these two businesses, then at year 5 Business A would be producing EBITDA of $1,610,510, compared to $1,276,282 for Business B. Since the Market Comparable approach suggested that both are worth $4.75 million today, a buyer would achieve a significantly different EBITDA return on investment (see Figure 3 below).
EBITDA Return on Investment 36.0% 32.4% 28.8% 25.2% 21.6% 18.0% Year 1
Year 2
Year 3
Business A
Year 4
Year 5
Business B
Figure 3 By valuing both businesses the same, despite differing growth rates, in year 5 the EBITDA return on investment would be 33.9% for Business A, but only 26.9% for Business B. If the risk factors were identical for both businesses, with the only difference being the rate of growth, might Business A have been priced too low?
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Now let’s look at the growth rate’s impact on value in a more rigorous way. So how can you estimate the impact of growth rate on value? A Discounted Cash Flow approach to value could be used, holding all variables constant except for growth rate, and then based on the resulting values, they can be looked at it in terms of a multiple of EBITDA and Seller Discretionary Earnings. This will allow for the comparison of multipliers that take into consideration the variance in growth rates, if all other things are equal. Using a Discounted Cash Flow (DCF) approach, the value of a business is derived by estimating all future operating free cash flow and discounting it at a risk-appropriate rate back to the present to arrive at a net present value of the investment. The DCF approach provides more of an intrinsic value, or investment value that is more focused on the risk and reward relationship of the investment. Following are a few scenarios to demonstrate how differing short-term growth rates can impact business value. The following assumptions were used: 1. At the beginning of the projections each business is assumed to have had annual Revenue of $5 million, EBITDA of $1 million, and SDE of $1,075,000. 2. Each business is assumed to have a primary owner salary of $75,000 which will increase by 3% each year. 3. Capital expenditures are assumed to be 5% of EBITDA. 4. For simplicity, taxes were estimated to be 30% of EBITDA. 5. The discount rate, long-term growth rate, and cap rate were assumed to be consistent in each scenario at 19%, 3%, and 16%, respectively. The long-term growth rate shouldn’t be confused with the 5-year short-term growth rate which is what is being varied in each scenario. 6. Operating Free Cash Flow (OFCF) is EBITDA less taxes, capital expenditures, and changes in working capital. For purposes of these illustrations, it is assumed that there aren’t net changes in working capital. OFCF is the cash flow used to calculate value using a discounted cash flow approach. 7. Terminal Value is calculated by taking the final year’s OFCF times (1 plus the constant rate of long-term growth) then dividing that by the capitalization rate. That terminal value is the estimated value at end of year five, and is discounted back to a present value (PV) using the discount rate. 8. Total Value is the combination of the present value of OFCF’s for years 1-5 plus the present value of the terminal value.
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Scenario 1 Short-Term Growth Rate is 4%. The estimated value is $4,166,986, which equates to 3.88x SDE and 4.17x EBITDA.
Scenario 2 Short-Term Growth Rate is 8%. The estimated value is $4,853,442, which equates to 4.51x SDE and 4.85x EBITDA.
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Scenario 3 Short-Term Growth Rate is 12%. The estimated value is $5,634,346, which equates to 5.24x SDE and 5.63x EBITDA.
Scenario 4 Short-Term Growth Rate is 16%. The estimated value is $6,519,809, which equates to 6.06x SDE and 6.52x EBITDA.
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A summary of the four scenarios’ imputed impact on SDE and EBITDA multipliers are as follows. Summary
An entrepreneur who owned a business with a 16% annual growth rate, but who sold the business using a business broker or M&A advisor who relied solely on a simplistic rule-of-thumb or market comparable approach in an industry with an average 4% growth rate, may have left significant money on the table (in the above scenarios a 36% lower price). It’s true that ultimately what any business is worth is what a business buyer is willing to pay for it, but an important role that the business sale intermediary should play in the sale process is to help buyers understand what the business should be worth and persuade them to pay it. Unfortunately, relying solely on a rule-of-thumb or market comparable approach will often fail to take into consideration the unique risk and reward characteristics of a business. The first part of Codiligent’s business sale process is to conduct a comprehensive quantitative and qualitative review of the business. This rigorous analysis establishes an appropriate value for the business that takes into consideration the unique risk and reward profile of the business. It also helps to transfer the business owner’s knowledge about the company to Codiligent which it then incorporates into information packages, marketing & advertising pieces, and prospective buyer communications. Codiligent delivers value to its clients in a variety of ways such as a comprehensive quantitative and qualitative review of the business, that results in: a more efficient process, fewer time-wasting meetings with inappropriate buyers due to better screening, fewer deals renegotiated after due diligence, greater probability of a deal surviving from Letter of Intent to closing, lower levels of seller financing, and better prices and terms. If you are thinking about selling your business at some point in the future, please contact Codiligent to discuss your business, situation, and exit planning goals.
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