VALUING AND PRICING THE COMPANY (Reposted)

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Dr. John Psarouthakis, Founder and former CEO, JPIndusries,Inc., a Fortune 500 industrial corporation. Publisher of www.BusinessThinker.com

Before you can begin final negotiations on price, you need to determine the value of the company. You can use several techniques to value a company.  We recommend the discounted cash flow value approach as the most accurate method although other approaches are useful in preliminary stages of your search to give you a sense of the range of the estimated price.

Timing and Scope of the Valuation Process

An initial calculation of valuation can be done on a fairly mechanical basis, based on information provided to you by the seller using established formulae and guidelines.  However, determining the accuracy of the financial data that the seller provides you is an on-going part of the evaluation process that should take place throughout preliminary and formal due diligence up to the closing.  Thus valuation takes place along with negotiations throughout the deal-making process.  One of the key objectives of due diligence is to surface any information that might affect the accurate valuation of the company. If your team does not have a financial auditor you should hire one to verify the accuracy of the historical data.

Once you verify the completeness and accuracy of existing documents, historical valuation of a company is often relatively easy from a technical standpoint. But it may be a fairly inaccurate reflection of what you can expect from the firm’s financial performance in the future.   Thus, although a preliminary valuation of the company might be done initially when you first receive financial data from the company, refining the financial assumptions about the company’s future performance must take into consideration a wide array of non-financial considerations.  Accurate forecasting requires a thorough understanding of general trends as well, trends specific to your industry, the economy, and of course a thorough understanding of the strengths and weaknesses of the particular company you plan to purchase.

General trends First of all, you should consider any social, technological, economic, political or legal trends that might affect future growth or decline of your company or industry.

Societal and lifestyle changes can also impact a company.  A growing population of senior citizens opens the door to more rapidly expanding health care related fields.

New competition or opportunities may come from outside your industry as new technologies emerge.   The television cable industry of the mid 1990’s awaits the impact of fiber optics as a new mode of conveying televised signals as a possible substitute product.

You also need to watch for changing economic patterns.  In exploring economic trends, consider the business cycle for your particular industry as well as more general swings in the local, regional or national economies in which you may do business.

No business today can afford to ignore ever changing political and legal trends.  They may create new problems but they can also spell new opportunity.   For instance, a ruling that cab drivers do not need to have a state license in Colorado has spurred a number of new cab businesses in that state, while putting some long established companies in some amount of jeopardy, reducing their monopolistic position.

The concern about the environment and environmental pollution has grown to the point that you may need to consider not only what the political and legal requirements are, but the expectations of the surrounding community, standards of which at times may exceed the minimum that the law requires.  Appropriate disposal of current waste, environmental toxins that workers might be exposed to and hidden problems from wastes improperly disposed of in the past all need to be closely scrutinized.

Understanding industry trends and the immediate competition Beyond the general trends, there are likely to be trends in your own industry, globally, nationally, regionally and locally.  To avoid being blindsided, you need to consider competition from each of these angles.   Businesses are often sold because a historically profitable firm is being threatened by new competition that the former owner is not sure how to respond to.  It does not mean that you should not buy a particular business, but you had better be prepared to respond to tougher competition.       

Understanding of the company itself In valuing the company, you also need to consider the myriad issues already presented in the formal due diligence chapter.  For instance, thorough due diligence may uncover somewhat artificially inflated short term profit data because equipment and facility renewal may have been deferred by the current owner.

In reviewing the company you plan to purchase, you need to consider its potential strengths and weaknesses in all the areas covered by due diligence.  In addition, you may want to consider the areas in which it is very capable, and the areas in which it is weak.  In today’s marketplace, being average is often no longer enough to maintain one’s competitive position.  A company must excel in areas important to the customers it serves, whether it is maintaining a discount price, fast service, high quality, or all three.  Many companies espouse these goals, but meeting these goals requires that the company builds in its capabilities in its marketing, production, management or in other aspects of operations. The future value of the company depends on the quality of functioning of the organization as an overall system, not on the particular assets it may have sitting in the warehouse or the orders in the sales department’s desk at a particular moment in time.

 Pricing versus Valuing

Valuation and pricing are not the same.  The company’s value is what it will be worth, with the improvements that the buyer plans to make to improve the company’s performance.  The company’s price is the amount that the buyer is willing to pay the seller for the company, regardless of its worth.

Why are price and value exactly not the same?  There are several factors that might influence the price.

How motivated is the seller?  An eager seller, perhaps someone with health problems impatient to settle his or her estate, may be willing to sell for a price below the company’s market value.  An unmotivated seller, one that perhaps had no intentions of selling until approached by a convincing broker to show his company to the buyer, may require a price higher than market value before willing to sell.

How will the company be financed?  If the buyer is depending heavily on borrowed funds from a bank, he or she is not likely to get approval on a loan for a company that is priced much above market value.  If the buyer needs to pay off the debt from the company’s cash flow, this will be closely scrutinized as well.  On the other hand, if the deal is largely a cash transaction between private parties, a bank’s opinion of the company’s value will not interfere with closing.  Of course, a buyer should proceed cautiously whenever paying well above market value but is less tied to the bank’s opinion when no banker is involved.

What is likely to happen to business in the near future? Although the discounted cash flow technique is more apt to reflect future earnings than some of the other methods, in any industry, the future is difficult to predict with total accuracy.  An industry predicted to head into a downturn is likely to command a softer price than an industry that is fairly clearly headed for strong, steady growth in the next three to five years.

What are the tax implications for both buyer and seller? Finally, another factor to consider in the price are the tax implications of the sale for both the buyer and seller.  IF the transaction is structured in a certain
way to improve the taxable position of the seller, this can affect the value.  Also, if there are tax benefits available to the buyer, he or she may be willing to pay a higher price.

 Different Methods for Determining a Company’s Price

      Calculating the value of a business can be complicated, however, there are business appraisers available to assist in this process. For example certified members of, the American Society of Appraisers, and / or  the Institute of Business Appraisers, Inc., can be of help.

Different authors will argue the benefits and disadvantages of the basic techniques for pricing a business.  For mid-sized companies, Lawrence Tuller identifies four common ways to value a going business1:

1.  Profitability or multiple net earnings method–which is based on a multiple of net profits;

2.  Net asset value–a very conservative method that looks only at the assets of the company, without counting value for goodwill;

3.  Historic cash flow–valuation based on the cash flow generated in the past; and

4.  Discounted cash flow method–the forecast of the cash obtained in the future.

In addition, the banks might look at the liquidation value of a company, the value of all assets if sold off immediately, especially for a loan they might consider as a high risk value.  This approach is even more conservative than the net asset approach because inventory and other assets are discounted heavily, assuming that a quick liquidation would require sale of assets at well below market value.

Within each of these general approaches, variations in computational technique may further lead to different results.             Which is the best approach?  If your criterion is ease of calculation, the multiple net earnings method might well be the simplest.  The discounted cash flow method is viewed by some experts as too complicated to use, but by others as the only accurate technique for valuing companies.  Let’s explore these different techniques in turn.

The profitability ratio

One takes the after tax profit from the previous year, uses a price/earnings ratio from a similar, but publicly traded company, and arrives at a value.  For example:

After tax profit last year     $ 2,000

Assuming a P/E ratio of           x  5

Value                         $ 10,000

Although this approach might be useful to establish a very wide price range to screen out candidates that are obviously too large or small for the buyer’s budget, it is viewed by most experts as a very misleading approach for establishing a more accurate level of price.  The key criticism of the profitability method is that it fails to take into account the difference in value based on differences in cash flow and differences in capital expenditures required to generate earnings.2 Two companies can actually have the identical sales and earnings but differ substantially in cash generated and capital expenditures required over time.

Value of assets

A second approach to valuation and pricing is based on the assets of the company, excluding its goodwill.

In early stages of negotiations, you are not likely to have direct access to information to make a determination of true market value of the assets.  For this reason, a common pricing tool is to consider the net book value of assets.  The net book value is the net sum of the depreciated assets, cash, receivables, buildings, equipment, minus the trade payables and accrued liabilities.  Different industries may have different multiples, as with the profitability method.  In the durable goods manufacturing companies that JPIndustries, Inc and JPE, Inc. investigated, for instance, a multiple of one or two is often used as a rule of thumb. If the asking price is much greater, say, three times book value of assets, it may be depleting its assets at a more rapid rate than depreciation schedules and would include a significant level of good will.  In the event of a high multiple, therefore, you have to be sure the nature of the business is such that it can operate at that ratio without major investments. The book value of assets can be deceptive.  Depreciation schedules often have little to do with the remaining market value of a particular item.  Computers for instance, often depreciate more quickly in value than the accounting rules might suggest.  On the other hand, real estate is regularly depreciated to zero dollars every ten years even though the property has plenty of retained value.  Thus, an appropriate valuation of assets requires a direct evaluation of the inventory, equipment, facilities and other assets.

Raw materials are generally easy to value, because such material can be purchased at a determined price.  Work in process is much more difficult because such material cannot be sold until more work is done to it.  Finished goods, once again are easier to value, especially if an established price has been set for the goods.  Accounts receivables have to examined closely.  More aged receivables are worth less than those less than 30 days old.  Older accounts receivables may be uncollectible.

Whether based on market value or net book value, the asset-based valuation approaches do not incorporate goodwill.  The total value of the company is simply the sum of the net assets.   Neither do these approaches take into account the time value of money.  They do often provide a bottom line figure of what the bank might be comfortable with but often generate figures too conservative for the seller to accept.  It might be an appropriate method where the seller is losing money, and the assets have immediate value to the buyer, perhaps a company in the same industry interested in the inventory and equipment.  However, as mentioned earlier, as a quick comparison to the valuation based on net earnings, as a way to identify potential problems in underutilization or over-utilization of assets, this approach can provide some insights into the prospective deal.

Historic cash flow approach

The historical cash flow approach is probably more similar to the profitability ratio method than to the discounted cash flow method.  Using the historic cash flow method, pre-tax profit is adjusted upward, by adding back in the depreciation, bonuses and owner’s draw, interest expense, and decrease in working capital.  Pre-tax profit is adjusted downward subtracting for taxes paid, increase in working capital, and purchase of fixed assets.  Using the historical cash flow approach,  an average cash flow is calculated for a multi-year period.  Then a multiple is applied which is somewhat arbitrary, once again varying based on industry or other norms.  Thus, for example, you might estimate that the average cash flow is $10,000 per year. In a particular industry, a multiple of five might be used:

Average cash flow/year:    $10,000

Multiple                   x     5

Valuation                                            $50,000

The historic cash flow approach is an improvement over the net earnings approach because it reflects actual cash rather than paper profits.  However, the historic cash flow approach still lacks a reflection of what is likely to occur in the future.  And as with the other approaches based on a multiple, the accuracy of the valuation estimate is very approximate, at best.

Discounted cash flow method

The discounted cash flow (DCF) approach to valuation is the only approach presented thus far which takes the time value of money into account.  That is, it recognizes the fact that a dollar today is worth more than a dollar tomorrow.  This is a very important concept in business valuation because you are basically giving the owner money today to gain the right to future cash generated by the business. To make a proper valuation, you should assess the value of the business relative to holding the money and investing it in some other way.  The DCF approach also factors in a forecast of likely future performance of the company, assuming no changes or improvements by the buyer.

Two key concepts essential to calculation of value, according to the discounted cash flow method are free cash flow and the discount rate.  Free cash flow is defined as the “after-tax operating earnings of the company plus non-cash charges less investments in working capital, property, plant and equipment, and other assets.”3  In the discounted cash flow model, future dollars are always considered to be worth less than present dollars.  The discount rate refers to the percentage that dollars (or other currency) reduce in value on an annual basis.  The factors that are often considered in calculating discount rate and the associated net present value include the opportunity cost to the buyer–that is, the return one could get for his or her money in other investments of the same risk, the tax benefit, and the after tax cost.  Deriving an accurate discount rate may be one of the most complicated but important aspects of applying this model.

Based on the DCF model, the total value of a company is equal to the sum of the present value of the company’s free cash flow and the present value of after-tax non-operating cash flow.  You add up the earnings flow for the next five to seven years, first discounting the contribution from each year to the net present dollar value based on the discount rate that you determine to be most appropriate in your situation.

Free Cash Flow:  An Example

Using the definition of DCF given previously, we can put together an example of estimating FCF for a hypothetical operation for a couple of years to demonstrate the components that must be considered in this type of calculation.

FCF  (in   millions)

Year

1

Year

2

Year

3

Year

4

Year

5

Revenues

20.0

24.0

26.0

30.0

32.0

Operating Costs

18

21

22

25

26

Operating Profit (EBIT)

2

3

4

5

6

Taxes on EBIT

0.4

1.2

1.6

2.0

2.4

Operating Profit after Tax

1.6

1.8

2.4

3.0

3.6

Depreciation

.5

.6

.6.

.8

.9

Operating Cash Flow

2.1

2.4

3.0

3.8

4.5

Change in Working Capital

0.2

0.2

0.3

0.4

0.4

Cap Expenditures

0.5

0.5

0.6

0.7

0.7

Other Assets Invest

0.1

0.1

0.1

0.1

0.1

Total Investment

0.8

0.8

1.0

1.1

1.1

Operating F.C.F

1.3

1.6

2.0

2.7

3.4

 

The average discount rate

The average discount rate and the resulting discounting factors can be estimated in accordance with the example below.  Let us assume that the debt is 30% of total capital and therefore the equity is 70%.  If the rate of opportunity is other investments is assured to be 10% for debt and 15% for equity, and the tax rate at the time is 40%, then we can calculate the average rate of discount as follows:

 

Capital

% of

Operating

Rate

Tax Benefit

After Tax

Cost

Portion of

Rate

Debt

30

9.5

40%

5.7

1.7%

Equity

70

14.0

– –

14.0

9.8%

AC of Cap

11.5%

 

The value beyond forecasted period:

It will be very cumbersome to estimate the value of a company that one assumes to have a life for an indefinite period.  A practical approach is to take a long enough period after which the discount factor is miniscule and calculate the value for that period.  A reasonable result is obtained by deciding the net after tax profit by the average discount rate.

The debt

The discounted value of the current debt should be estimated by using a rate that corresponds to the market rates of similar risks for debt.  Future additional debts should not be included in the calculations since those debts would be balanced out by the repayments, appropriately discounted for that debt.

Equity

Finally, the equity value and correspondingly the value of the company is the sum total value from the operations for the forecasted period of ten years in this case and of that beyond the ten years minus the discounted value of the debt.

Let us look at an example of discounted free cash flow evaluation.  Let us suppose we are looking at a prospective acquisition candidate that its free cash flow for operation is calculated for ten years forward.  The discount rate factor is also estimated for these ten years rising at an average discount rate of 11.5%:

 

Year

Forecasted:

Free Cash Flow

Discount Factor

at 11.5%

Present Value:

Free Cash Flow

1

1.3 0.90 1.2

2

1.6 0.80 1.3

3

2.0 0.72 1.4

4

2.7 0.65 1.8

5

3.4 0.58 2.0

6

4.0 0.52 2.0

7

4.5 0.47 2.1

8

5.0 0.42 2.1

9

5.5 0.38 2.1

10

6.0 0.34 2.0
Value beyond 10 Yrs 58.0 0.34 20.0
DFCF from Operations 38.0
Debt 25.0
Equity 13.0

 

Which Technique to Use?

You may find it useful to use several of the valuation techniques presented in this chapter at different points in the negotiations process.  The profitability and value of assets methods provides a quick assessment of the general value of the company early in the negotiations process, and does not require much technical assistance.  However, as you get closer to finalizing the price you wish to pay, you are advised to obtain the assistance of an appraiser experienced in the discounted cash flow approach, to obtain a much more accurate valuation of the company.

Early in the process, our team calculate the net book value of the assets of a prospective company and then compares it to the value of the company based on the profitability ratio, using a P/E ratio of 5.  Then the team makes a judgment as to whether the relationship between assets and price makes sense.  If the assets are much lower than the value based on the earnings, it looks more closely at the company’s fixed assets to make sure that the equipment and facilities have been kept up to date and whether other necessary investments have been made to keep earnings at that particular level in the future.  As mentioned before, owners of companies with low assets compared to price may have stopped investing in the future of the company.

The next step in the valuation process is to carry out the more detailed discounted cash flow analysis, looking at the next three to five years, based on current operational plans, not those necessarily that JPE, Inc., plans to implement.  This is important. You should never value a company based on how you think you can get it to perform after changes are made.  The valuation should be based on what the owner is presently doing.   In sum, our acquisition team used at least three of the valuation methods — net book assets, P/E ratio and discounted cash flow methods — in succession as it get more involved with a company and is able to learn more about it.  However, the discounted cash flow method is considered the most accurate of the three and the one upon which final value is most closely based.

Other Factors to Consider in Pricing a Company

Once you have developed a fairly rational assessment of the value of the company, using the combination of methods described, you still need to arrive at a price that you feel is appropriate to pay for a particular company.  There is no set formula for this, because the worth of a company will vary depending upon the buyer. An important concept, especially where an existing company buys another company, is the potential synergy of the acquired company with the buying company.  Bill Pursche (1988) identifies three types of synergies, universal, endemic and unique.

Universal synergy Universal synergy is generally available to any acquirer with capable management and adequate resources.  Examples of universal synergy might be an economy of scale or larger market share in an industry.

Endemic synergy  By contrast, endemic synergy may be available to only a few acquirers, perhaps companies already in the same industry.

Unique synergy Finally, a unique synergy may be an opportunity that can be exploited only by a specific buyer (or seller).

Although these categories are more typically applicable to existing companies purchasing others, individual buyers may vary in their skills and background and thus gain greater or less benefit from a particular purchase.
Some Differences in Valuation across Industries

The nature of assets are a key factor that affects the valuation procedures across industries.   A manufacturer can more easily identify hard assets such as machinery, equipment, tools, receivables, inventory and buildings.  By contrast,  the asset approaches are much more difficult to carry out and perhaps less relevant in service businesses where goodwill constitutes a large part of the company’s value.  Because the discounted cash flow method does not depend upon valuation of assets, it can be more universally applied.  However, due to the lack of hard assets, banks may be more reluctant to finance purchase of service companies.   Although this is a financing issue, it can also dampen the overall price.

Other valuation-related issues should be considered in the service industry.  In a service business,  you are basically buying intellectual property.  It is much harder to test the value of intellectual property than in manufacturing, where you can see, touch and feel property for quantity and quality.  For the service company, you need to evaluate whether the services offered are state-of-the-art, if those services are needed in the market, if the services will sell, and if those services have a future. You also need to consider the uniqueness of the business.  The company’s uniqueness may stem from legal protection, such as a copyright or patent, or may stem from the unique capabilities of the technical or management people assembled, or the long term relationships built with customers.

Also consider compatibility when valuing a prospect.  When Burroughs bought Sperry Rand, for instance, their software and design were not compatible and they had a hard time rationalizing the two businesses.  Eventually, the conglomerate shrank back to the size it had been before Burroughs acquired Sperry.

Cultural fit is another consideration, for both service and manufacturing.  If you have a culture surrounding one person, when that person leaves, the company may not have the same value.  It is preferable to purchase a company with knowledge and leadership that is more widespread.  You cannot force anyone to stay, even with an employment contract.

It is important to remember also that multiples vary by industry, if you plan to use the profitability ratio or the historic cash flow methods.  You need to find other comparable companies that have been bought or sold, which might be difficult in an industry that has few transactions.

Footnotes

1 Tuller, Lawrence, Buying In

2 Copeland, Tom, Koller, Tim and Murrin, Jack, Valuation: Measuring and Managing the Value of Companies ,New York: John Wiley and Sons, 1990. Chapters 3 and 4.

3 Copeland, Tom, et al, Valuation: Measuring and Managing the Value of Companies .

4 Pursche, Bill, 1988.

 

SUGGESTED FURTHERREADINGSFOR VALUATION

Merfeld, Eugene and Gary L. Schine, How you can buy a business without overpaying,New York: The Consultant Press, 1991, Chapter VII, Valuing the Business.

Copeland, Tom, Koller, Tim and Murrin, Jack, Valuation: Measuring and Managing the Value of Companies , New York: John Wiley and Sons, 1990. Chapters 3 an

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Reference: “How to Acquire the Right Business”

John Psarouthakis & Lorraine Uhlaner

Published by Xlibris, 2009

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