Valuation: adjustments

In our prior article, we started to address what adjustments we need to make to a firms earnings so that we can more reliably predict future cash flows. These are key to building a reliable DCF valuation. Last week we discussed how to adjust for non-market related owner’s compensation and discretionary expenses. This week we’ll look at how to treat one-time losses/gains, periodic expenses, and non-operating expenses.

Dealing with once-off losses or gains:

Once-off expenses or gains are reported below the Net Income line of the Income statement. They most commonly occur because part of the operations of the business have been discontinued – typically a product line, a regional branch, or a manufacturing process. It’s very easy to deal with the impact of this if it happened in the current year – simply remove its impact from Profit Before Tax and re-calculate accordingly. However, most often we are looking at the last 3-5 years of financial statements and we may find such once-offs in years 2 and 4, for example. Since what we are trying to do is build a reliable history of the firm (to improve our predictions of its future growth potential), we need to add back those once-off losses (or subtract such gains) to the Profit Before Tax number for each year and recalculate our Net profit accordingly. The skill comes when trying to estimate how much profit (or loss) should be applied to the years before the actual adjustment, since in each of these years there has been expenses or income from these discontinued operations mixed amongst the recurring business. The shortcut here is that if the once-off gain/loss was less than 10% of the profit for a year and if it happened 3 or more years ago, then you can fairly safely ignore it and focus on the more recent years instead. If the adjustment is in the current financials, then its much harder to put much certainty on future earnings. Dig deep to understand the likely impact.

Periodic expenses:

Most expenses in a business happen more or less predictably each year. Yet ever so-often there are major expenses associated with something that doesn’t happen every year, isn’t always predictable, but does happen and is a major expense or disruption. Know any of these? The most common one I see is moving expenses. Having gone through several office moves myself these not only incur costs (and emotional debate about choices of finishes and parking allocations) but also impact sales and productivity, sometimes for a while. If you’re buying a business its location is often a major part of the deal: some businesses are bought purely for the value their location brings, in others, moving the business 1 block away could make or break it. The key thing to understand is when the business is next likely to move (or incur any other periodic expense) and to provide for the impact this would have. As a hint, look at the terms of the lease to get a feel for how soon this would happen. If you are unsure, then take a reasonable estimate and provide for it in each of the next 3-5 years. The other classic periodic expense is legal action – most companies face legal action from trading parties, former employees or customers sooner or later. Their unpredictability and importance means that the sellers often indemnify the buyers of a business from legal action as part of the sale agreement.

Non-operating expenses:

These are more complex. Years ago a business where I worked leased a house in a popular holiday spot and reflected this on the books as a ‘conference venue’. It was merely a perk for staff and some clients who made use of it, and wasn’t integral to the business – a classic non-operating expense. The local example I come across regularly is the ‘box’ at the local sports stadium – these are primarily used for entertaining clients and become an on-going non-operating expense that needs to stay in the books. In general, non-operating expenses are a region of adjustments where you need external advice, especially if anything is big and chunky or requires long-term renewal shortly after you intend doing a deal.

By now, I hope you’re getting the picture as to why it’s important to go through the firms’ existing and historic statements and the types of adjustments we need to make before we can determine the realistic picture going forward. In next weeks’ article we will wrap up this section with a worked example (the published notes will be supplemented with a downloadable Excel spreadsheet).

This article originally appeared in Finweek

Valuation: diving into the Discounted Cash Flow model

Probably the most key point for anyone to understand when valuing a business is that the historical performance of the business is relevant only as a reality check for the future; in valuation we are concerned only with the present position and the future economic benefits we expect from the investment.

Readers will recall that there are 4 major steps to calculating a DCF (Discounted Cash Flow) valuation:

  1. Forecast cash flows (typically we end up with a range of scenarios).
  2. Discount them to present value (the discount rate used need to reflect the risk associated with the business or the desired rate of return the investor wants on his/her money).
  3. Adjust for the level of control (if you own a minority stake in a business you have higher risk than if you own it all).
  4. Adjust for the level of marketability (some business are far more easily sold than others).

Today we’ll focus most on how to forecast cash flows: it’s the hardest and most crucial step and almost all our final result depends in getting this right.

To start with, we need the income statement from the current/most recent period: our aim is to use this as a template from which to forecast sales and net income going forward.

Remember that in this column we are trying to make ‘big company’ finance applicable to smaller, privately owned businesses, so there are going to be some adjustments we need to make first. These adjustments are necessary because we have to separate the business from the owner. Whereas in large corporates who are closely watched by investors, regulators and accountants, what typically happens in smaller businesses is that this separation of business and personal isn’t precise. The result is that personal expenses are ‘washed’ through the business; the owner is paid more (and quite often less) than the market rate for a manager who could replace him/her; and that ‘cash sales’ never appear on the books and are thus tax-free.

Here are the major steps we must take in order to adjust the reported income of the business to its ‘real income’:

  • Adjust owners’ compensation back to what it would cost to get an independent manager to do the same job.
  • Add back discretionary and personal expenses and unreported personal receipts.
  • Add back one-time losses and subtract once-off gains.
  • Allocate periodic expenses appropriately.
  • Adjust for non-operating expenses.

Owners’ compensation adjustments:

The key question to ask is what an external owner would pay for a manager to run the business in their absence. If you are considering buying a business, then what you need to remember is that if the business only generates enough to pay the owners what they would have to pay someone else to do the work, then the business is just a job. You’d be surprised at how many people don’t get this right – often because they’ve ‘always wanted to run a bakery/fix cars/consult to businesses’ and end up buying their way into their dream job. Getting back to the adjustments we need to make, most owners don’t pay themselves appropriately. Either they pay themselves and other family members they employ higher-than-market rates (in which case the need for each job must be questioned and expenses reduced to market rates), or they pay themselves too little so that the business looks like a better investment. Here you need to increase the expenses accordingly; we are trying to understand what it will be worth to us, not what is has been worth to them.

Adding back discretionary expenses:

We add these back (including charitable contributions and non-declared cash) because the owner has a choice on where to spend this cash and it could be expected to flow through to profits. However, not all charitable donations are really discretionary; for example a business might sponsor a charitable foundation that is aligned to a key supplier. Stopping this spend has the potential to change the business relationship and so it should reasonably be expected to continue.

How to treat undeclared income:

Many small businesses have some form of sales that happen on a cash basis, not all of them choose to report these. The primary reason for this is that they evade the tax on the non-declared income. Note that although fairly common this is illegal and I strongly advise against it. Most sellers would love you to know that the business has extra profits of x% and they’d love you to pay for that. Don’t. Let me repeat – don’t ever base your valuation off any undeclared income: you are simply asking for trouble. If you are the seller and you want to achieve a higher price, then declare the income and at you’ll get a multiple on it that way. If you do have undeclared income then beware that telling a potential buyer of this means that they might have a legal duty to report you to tax authorities.

We will cover how to treat once-off expenses/gains, periodic expenses, and non-operating expenses in next weeks’ article.

This article originally appeared in Finweek.

Valuation: introduction to the income approach

Previously, we’ve discussed the Asset approach and the Market approach to valuing your business. Our conclusion so far is that determining the liquidation value of your business has some merit (you’ll understand your worst case) and that market-based approaches are fraught with problems of comparability and data collection, to the point of being generally unreliable.

Today we’ll discuss the Income approach and introduce the Discounted Cash Flow (DCF) valuation.

Upfront, we’re going to argue strongly that a DCF is the only real valuation method one should use. It’s useful and reliable both as a measure of the fair market value of the business at a point in time, and its also very useful as an on-going management tool: a DCF valuation is one number which shows the combined effect of external and internal environments, and allows the user to understand the trade-offs between almost any resource allocation decision (i.e. strategy, operations, capital structure, dividends, etc.) and across any time period. In other words, this is important stuff and you need to pay attention!

In the Income approach we attempt to calculate expected future economic benefits from an asset and covert those into a single amount today. These future benefits can come in the form of dividends paid to shareholders, cash flow earned by the business, or net income earned by the business, each of which can be estimated going forward and discounted back to today.

Discounting future dividends is problematic because it values only the flow of money a shareholder receives through dividends, however dividend policies vary significantly from firm to firm and can be changed at short notice by management. Firms can also hold huge cash reserves (which are economic benefits owned by shareholders) yet not declare dividends at all. So the method isn’t generally applicable and in the small business world we should focus efforts on more reliable methods: by discounting cash flows (DCF) or Net Income (DNI).

The DCF forecasts future cash flows and discounts them to present value, the DNI forecasts future Net Income and discounts that to present value. They are essentially doing the same maths yet using different numbers. So which is better?

Simply put, you cannot pay your bills with net income – you can only pay bills from cash flow. So if you are to measure the value of a firm you want to know about its cash flows far more than its profitability and the DCF is a fundamentally better approach. Secondly, cash flow includes net income, yet net income doesn’t include cash flow, so cash flow is a more complete measure. Thirdly, the world of finance trickles downwards (from sovereign-level funding to public markets and finally to the little guys), and the rates of return that are used to value big companies in public markets are based on cash flows, not net-income. For me the most important reason to use cash flows rather than net income is that the former accounts for both dividend policy (i.e. how much of net income is retained in the business to fund future growth) and capital structure (how much debt is used to fund growth), both of which significantly alter the growth potential and risk profile of the business and thus its’ valuation.

So what are the steps in calculating a DCF valuation of a firm?

  1. Forecast cash flows (typically we end up with a range of scenarios).
  2. Discount them to present value (the discount rate used need to reflect the risk associated with the business or the desired rate of return the investor wants on his/her money).
  3. Adjust for the level of control (if you own a minority stake in a business you have higher risk than if you own it all).
  4. Adjust for the level of marketability (some business are far more easily sold than others).

Today has been a big terminology dump and the good news is that from here on out we worry only about the DCF valuations. We’ll go into specifics and a worked example next week. It’s a powerful tool and I’m looking forward to it!

This article originally appeared in Finweek.

Valuation: the market approach

There are 3 broad approaches to valuing your business. Previously we discussed the asset-based approach and concluded that taking the time and effort to understand the liquidation value is worthwhile, simply because it gives you an understanding of what you’ll get out in the worst-case scenario, which is generally not very much at all.

Today we’re going to discuss the Market approach. It’s an important discussion because you’ll find it all over the place, and seemingly rational people will like to tell you that it’s reliable. Please bear with me while we discuss the approach and debunk the myth.

The Market approach sounds simple: we attempt to find comparable businesses with known valuations (i.e. where transactions are actually happening/have recently happened at a known price) and apply a set of adjustments to derive the value of the target firm.

Big companies do this by comparing themselves to listed companies in the same sector (the ‘Guideline’ companies). These need to be in the same line of business as the target and must be actively traded on the free and open market. With public companies this approach works well if

  1. The sizes of the firms are similar – there are many reasons why the profitability and risk associated with a large company would be very different to another half its size,
  2. There are many Guideline firms in the same industry (you want 10 or more, ideally),
  3. There is forecast data on the Guideline companies (not always available) and
  4. That the PE multiples are fairly consistent across them.

Obviously there is a lot of skill and care require in selecting and understanding the guidelines firms, however the real dangers lie when one tries to compare public companies where PE ratios can be 12-40 or higher with private companies where the range is more like 4-6. Keep in mind too that shares in public companies are tradable almost instantly whereas shares in a private firm might take a year or more to sell. The level of risk is almost incomparable, and that should say it all.

When using the Market approach with privately held firms, one is trying to compare the firm with Guideline businesses that are also privately held. Depending on the size and nature of the firm financials may not be audited and will almost certainly have some unreliability. (This is because public companies are far more ‘watched’ by the markets, analysts and regulators). Also, valuation is mostly dependent on the future of a firm, and it’s very hard to find forecast information for smaller businesses.

The result is that this method is practically unusable, with the possible exception of comparing one franchise branch with another (for the simple reason that the business model, costs, etc. would be almost identical). Even here there is danger: for example a restaurant (i.e. a well understood business model) of the same franchise with exactly the same financials at a point in time can face a very different future (depending on local competitor action, demographic changes, and a host of other reasons)…and thus it will have a very different valuation. The market approach does not take this into account and thus its fundamentally flawed.

The Market approach is exactly what most Estate agents do when estimating what your house is worth, and since business brokers are often ex-estate agents, it’s unsurprisingly the approach they favour. The problem is that businesses are far more diverse than houses or even offices and do not easily lend themselves to comparison. For example, while hundreds of homes might have been sold in your suburb in the last 5 years, its unlikely that even 10 businesses similar to yours have been sold in the whole city in the same period. While not wanting to taint the value of the few exceptional brokers out there, be wary of anyone who offers a ‘free valuation’ based on the Market approach. There is a very real risk that you’ll be treated as average, or compared to something unrelated, and leave money on the table.

At we include the market approach only as a point of comparison in our analysis for SMBs, yet almost every discussion with an entrepreneur opens a discussion around ‘what multiple of PAT the business should be worth’. Use your head and don’t fall for this trap.

Next week we’re going to put some real numbers behind the science and art of valuation, looking hard at the Income approach and Discounted Cash flow. We’ll end up with something reliable both as a Fair Market Value and as an on-going management tool, which opens up a whole level of business understanding and value creation.

This article originally appeared in Finweek.

Asset-based valuation

We’re going to begin our discussion of valuation methods and dispel some myths along the way. Our aim is to understand how people attempt to place a value on something as complex as a business; each method has its pros and cons and they’re important to understand because this one number that we call valuation can have a lot riding on it. Keep in mind that we’re trying to establish our Fair Market Valuation (FMV) of the business; the eventual price may differ from the valuation depending on how ‘free’ the market is at the time of transaction.

Readers of this series will recall that there are 3 broad approaches:

  1. The Asset approach: which measures the value as ‘assets net of liabilities’
  2. The Market approach: which compares the business to other recent transactions of a similar nature, and
  3. The Income approach: which attempts to measure value by converting the stream of expected economic benefits (profit after tax, cash-flows, or dividends) into a single present-day amount.

In this article we’re going to focus on the Asset approach, deservedly leaving the Market and Income approaches for their own treatment in the next few articles.

In the Asset approach we look exclusively at the balance sheet and try to understand what the assets of the business are worth.

Using the ‘book value’ method is dangerous since accounting standards are by nature conservative and tend to under-report the true value of an asset. For example, a machine that produces half the output of the firm might already be depreciated close to zero on the books. Its value would thus be horribly understated relative to its productive worth or even its value in a sale. (Debts are typically reported fairly accurately on the books, so it’s the asset side we need worry about).

The ‘adjusted book value’ method attempts to compensate for these by calculating the FMV of each asset on the balance sheet and thus adding up to what the FMV of the business is as a whole. While this sounds great, not only does it rapidly increase the cost and complexity of doing the valuation work, with specialist knowledge often required for property, machinery etc., but it totally ignores intangible assets that are not currently on the balance sheet. These can be substantial. The result is further cost, further subjective (if expert) opinion, and further potential for money to be left on the table one way or another. We remain unconvinced of their value, especially where any Intellectual Property or Goodwill are involved.

Business wanted, dead or alive:

The last asset-based method is to calculate the liquidation value of the business; here the purpose is to calculate whether the business is worth more ‘dead or alive’.

This method has some real use, mainly as a counter point to the DCF valuation we’ll use to determine the ‘going concern’ valuation down the line. In the ‘dead’ scenario we would be faced with closing the company and liquidating assets into cash, which would be used to pay off creditors and the balance would be returned to the equity holders. To calculate this, we restate all the assets and liabilities to their net realisable value if the company were to liquidate. This too requires some skill. Keep in mind that an asset that would normally be sold for say, $500K might only reach 25% of this or less in a liquidation sale. (Hence why so many restaurants kitchens are equipped largely from the used parts of those who’ve failed before them).

We still have to add in extra costs of actually winding up operations, laying off people, buying out the remaining period on a lease, selling the assets, and additional accounting and legal expenses. This again is a complex exercise that requires skill, line-by-line estimations, and additional costs. At the end of all this, if the business is worth more as a pile of cash post liquidation than its value as a going concern, then that’s our best route forward.

Does liquidation meet the criteria for a ‘FMV’? Yes: even though a business might be on the ropes its assets may still each have value. The liquidation value merely reflects the situational urgency of the seller, the market is still free and fair.

Do big corporates use this approach? Absolutely: while the objective is preferably to sell a business as a going concern to an industry buyer, it’s often faster, cheaper and simpler to dump equipment and facilities, particularly when they also take up overhead or other shared expenses which can also be reduced if the business is shelved, thus increasing the profitability of the remaining firms in the portfolio far more.

We suggest you include this approach for any business that appears marginal, or where bankruptcy is likely in the next 12-18 months. It answers the question ‘what will I get out if it all goes wrong’, and anyone lending you money needs this answer too.

This article originally appeared in Finweek.