Valuation in Buying or Selling
By Matt Dickstein
buyer and the seller should value the seller's business (the
target). Buyer does so
for obvious reasons, and target does so to determine the
asking price for the business.
In buying a
service industry business, there are 2 common methods for
valuing the business: discounted earnings, and comparable
change of control transactions. To the extent both methods
are available, buyer will use both. Usually, however, buyer
will rely more on the discounted cash flow method, because
insufficient market information will be available to fully
use the comparable sales method.
ordinarily don’t buy a business as an “investment” (you
invest in the public markets instead). You buy a business
because you want to run the business or you see a special
fit between the business and your current operations.
basic question for buyer is, given its projected uses for
target and its objectives in acquiring target, what is
target worth to buyer? The earnings method explained below
helps make more clear target’s intrinsic worth, and the
comparable sales method helps buyer know that it’s in the
right ballpark. Although both valuation methods can assist
buyer, the real analysis for buyer will concern buyer itself
– what are buyer’s objectives for the acquisition, and what
does buyer hope to obtain by virtue of the acquisition?
Target should know buyer’s objectives as well, because
target will receive a premium purchase price to the extent
it can help buyer meet those objectives.
a service firm, the No. 1 factor is determining the earnings
potential of the firm. There is no magic formula, buyer
simply takes earnings and multiplies it by a factor that
takes into account risk and premiums. In other words, buyer
bases price on a multiple of EBIT, and to determine the
multiple, buyer considers factors like the stability and
skills of the worker base, the stability and attractiveness
of the customer base, and market penetration. In the end,
buyer wants a firm with an established client base, a proven
revenue stream, and a stable core of employees.
That said, I do have a model for valuation that helps you
see the factors and how they fit in. Real world valuation
is much more complex than my model, however. Use the model
only to see how the pieces of a valuation analysis can fit
Basic Principal: Value a
business at the present value of the expected income stream
over a term of years. That is, quantify the future income
stream, then discount for risks and add in for premiums,
then calculate present value.
Earnings X Number of years (base the number of
years on employee and client stability)
Risk discounts and premiums (expressed as a
Present value discount
Step #1: Calculate Earnings.
Start with complete financial statements for the past 3
years, the owners’ tax returns for the past 3 years, and
current agings of accounts receivable and accounts payable.
EBIT (operating profit)
Cost of sales + selling/admin expenses
EBIT does not take into account how target’s financing,
leverage and taxes have affected its earnings.
Now adjust EBIT, because service
firms usually are smaller companies that can and will be
flexible in financial matters. For example, the owner may
have been anticipating a sale of the business, and therefore
may have been pumping up earnings by not making needed
capital expenditures. Reduce EBIT for capital expenditures
that should have been made. Also reduce EBIT to account for
the cash needed to bring working capital up to a secure
level. On the other hand, owners try not to show a profit
for tax purposes. Instead they expense out profits in the
form of salary and perks. Increase earnings to the extent
paid out as extra salary and perks.
Step #2: Project Over a Term
of Years. Next, estimate the duration of the EBIT
income stream. For a service firm, you can base the
duration of income stream on the average retention of each
client, where you weight the clients based on their dollar
billings, and on the average retention of billing
employees. Because a stable client stream and a stable
employee base are difficult to build, buyer might consider
applying a multiple to the average retention.
Step #3: Calculate a
Projected Income Stream. The result of the above
calculation is a number that reflects target’s projected
income stream: “EBIT X years.”
Step #4: Discount for Risks.
Here you express risk as a capitalization rate, that is,
you express each risk as a percentage and apply it to the
“EBIT X years” number.
Client Loyalty to Individual
Principals. It’s not easy replacing an owner /
operator. Target can mitigate this risk by having the
principal stay on as a consultant, retaining the principal
as an employee and using no-compete agreements.
Target and buyer can work together to see that key employees
will remain with the firm after the transaction.
Corporate / Legal Issues.
All shareholders should have clear title to their shares,
and be willing to sell. Target should have cleared up all
litigation and other claims against it.
Earnout. Because it’s so
difficult to quantify risk, most buyers adjust for risk by
using an earnout. Target should take all measures possible
to mitigate risk prior to negotiations. Target’s
preparation can reduce or eliminate the earnout.
Step #5: Add in Premiums.
Just as with risks, you express reward as a capitalization
rate. Target gets the maximum purchase price by showcasing
its value. Different buyers will see different values in a
company, and will be willing to pay different amounts. For
example, a buyer that only wants the hard assets of a
business will pay a low, liquidation value price. Buyer
will pay a premium if it wants to take over target’s
business and income stream, or if it sees a critical fit
between target and buyer’s future growth.
Attractive targets have a value that is hard to replicate.
Buyer will buy target to get the value, that is, buyer
cannot practically or quickly develop the value on its own.
Examples of factors that create a premium purchase price
Synergies between Buyer and
Special Expertise. A
service firm’s primary income generating asset is its
skilled, billing employees. The question is, how much are
the people in the firm worth in terms of their ability to
generate income? Typically, the more specialized and
technical the skills of the employees, the more valuable the
Turnkey Operations. Look
for a stable employee base and stable operations.
Attractive Client Base.
Look for stable “institutionalized” clients, with
Good, Long Term Lease.
As for finding a buyer that is
willing to pay a premium, target’s best hope is its own hard
work. Well in advance of the estimated time of sale,
target’s principals should be out talking to friends and
competitors in the industry. The subject of conversation is
not target’s impending sale (which should not be revealed),
but rather about the industry itself and how a firm can grow
to best take advantage of opportunities. Merger and
acquisition ideas will naturally come up, based on strategic
fits. And now target has found its premium.
Step #6: Calculate Present
Value. Calculate the sum of money that today would
equal the total purchase price calculated above over the
term of years. The discount rate can be the 1-year Treasury
/ comparable sales method for valuation requires an active,
transparent market, and an exchange of comparable
businesses. The best example is the home real estate
market, where comparable sales exist just down the street.
Unfortunately, for us, no two firms are the same, buyers
have different purposes for the acquisitions, and the market
is not transparent. In sum, it is very risky to base a
purchase price on a comparable sale. That said, however, we
recently have seen and heard 2.5X (more or less, but prior
to the recent downturn) as a common multiple over EBIT for
the sale of an IT firm.
can use the following websites for transaction data and
Factor in Costs of Financing
should take into account its costs of financing the
acquisition. That is, the expected rate of return from the
acquisition should well exceed its costs (such as interest
or equity dilution) in obtaining the funds used for the
Calculations for Purposes of Comparisons within your
have the basic measuring stick (EBIT), you can do more
calculations. First determine the service firm’s profit
margin. Use profit margin for comparisons with target’s
prior years to see if it is getting more profitable, not
just bigger. Also use profit margin to compare with other
service firms in the industry. You are looking at
profitability and operational efficiency.
Next, use EAIT (earnings after interest and taxes) to get to
target’s bottom line. Here determine taxes at the standard
rate, not target’s actual rate.
EAIT (true net profit)
Finally, determine the service firm’s net profit margin.
Net profit margin shows how much profit buyer can expect to
derive from target on a yearly basis.
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