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Valuing Businesses Using Regression Analysis C. Fred Hall

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Valuing Businesses UsingRegression Analysis

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Tothetwogreatladiesinmylife;mybrideofnearly50years, Joanie,whohasproofreadeveryoneofmy800valuationsand isstilltalkingtome.Sheprobablyknowsmoreaboutvaluationsthanmostoftheprofessionalsintheindustry.Duetoher greatlifeexperiencesofhavingworkedwithmanyCPAsand attorneys,shehasagiftofbeingabletoreadcomplicatedtext andthenhelpmetorewriteitinplainEnglish.Shehasmade melookawholelotbetterthanIam.

Tomymother,Connie,whoforthelastfiveyearshasconstantly givenmeencouragementtowritethisbook.Shewassohappy tohearthatthedreamwasgoingtobecomeareality.Unfortunately,shepassedawayat99yearsjustbeforeitwaspublished.

Foreword

Asanexecutiveandentrepreneurforthelast30years,I havebeenregularlyinvolvedinbusinessdevelopment, marketing,businessbrokerage,andbusinessvaluations.Every newproject,itseemed,startedwithavaluationofthebusiness. ForyearsIdidmyownvaluations.However,Iwascontinually frustratedwithhowthedifferentmultipliermethodologies producedwidelydivergentvalues.Conventionhadusaverage thedifferentvalues,butIneverhadconfidenceintheresulting value.Needlesstosay,whenpresentingmyfindingstothe ownerofthebusiness,heorshewouldnoticethatoneortwo ofthemethodologiesproducedaveryhighvaluecomparedto theothervalues.ThequestionalwaysaroseastowhyIwas notusingthehighervalue.

Ialsoworkedwithmanypotentialbuyersofbusinesses. WhenIwouldshowthemmyresearchontheestimateofvalue, theywould,ofcourse,focusonthelowervalues.Sufficetosay, conventionalmethodologiesoftenbroughtupmorequestions thananswersand,assuch,neversatisfiedanyone.Fiveyearsago IwasintroducedtoC.FredHall,III.Heexplainedtomewhy thedifferentmethodologiesproducedsuchdifferentvalues.It madesense.Idecidedtousehimtovaluemyclients’businesses ratherthandoingsomyself.Inthelastfiveyearswehavecollaboratedonover100deals;morethan80ofthemrequired valuations.

Whentakingabusinesstomarket,theaskingpricemustbe reasonableorpotentialbuyerswillneverrespond.Thevalues producedbyFred’smethodologywerespoton.Wehadvery fewcrediblechallengesontheaskingpricesbyeitherbuyers orsellers.AnotheraspecttoFred’sapproachistoensurewe

arecomparinglike-kindbusinessesthatare“performingatthe samelevelasthesellers.”Sellersappreciatethistypeofcomparisonvs.usingatypicalaveragemultipleforanindustry.Fred’s methodcanappearcomplicated,butthechartsproducedby theregressionstodeterminetheappropriatemultipliersforthe companyaresocompellingthatthereislittleonecanargue about.Anyoneinvolvedinbusinessvaluationsneedstoadopt Fred’smethodology.Itworks!

Ishouldmentionthatasaresultofthebusinessesbeing properlyvalued,Iwasabletoclosefarmoredeals.In2017 theInternationalBusinessBrokersAssociationhonoredme withtheChairman’sCircleAwardasoneofthetopproducing brokersintheUnitedStates.In2018and2019Iwasawarded “OutstandingProducer”honorsaswell.Fred’svaluation methodologyhasbeenabigpartofoursuccess!

RandyHendershot, CEOofEvolutionAdvisors, CBB

Preface

AfterfinishingmyMBA,Iwenttoworkforamajorwest coastbank.Ichosethebankbecauseithadoneofthetop managementtrainingprogramsintheindustry.ThiswasimportanttomebecauseIfeltthatmyMBAtrainingleftmeclueless aboutbusinesses.Iwasright.Thebank’smanagementtraining programwasanintensenine-month,40-hours-a-weekclass,on analyzingbusinesses.ItwasequivalenttoasecondMBAdegree. UponcompletionofthetrainingIwasconfidentthatInow understoodbusinesses.Iwaswrong.Itwasn’tuntilIownedmy ownbusiness(ImustclarifythatmywifeandIownedit)that someofthelightswenton.However,itwasn’tuntilwesoldthat businessafter27yearsandIthenwenttoworkasabusiness brokerforamajorbrokeragefirminnorthernCaliforniathatI begantoreallyunderstandbusinesses.

MBAeducationwaslargelytheoreticalinthosedays,and bankingwasthetechnicalapplicationofthattheory.However, owningyourownbusinessteachesyoumanythingsyouwould neverlearninschool:thateducationislargelyonthefly.Asa soleproprietor,yourskillset,forthemostpart,isself-taught, andclassisinsession60hoursaweekfortheentireperiodof ownership.Ithoughtallthatknowledgewasuniqueandoriginal.However,after18yearsofbeingabusinessbrokerand businessappraiserandhavingworkedwithover800business owners,Ifindthatweallseemedtothinkalike.Wemadesimilar choicesandsimilarmistakes.

WhenIwasconsideringsellingmybusiness,myfirstchoice ofpotentialbuyerswasmygeneralmanager.Heworkedfor meforover20years.Hewasveryloyalandmademealotof

money.IthoughtIowedhimtheopportunitytobuymybusiness.Thiswasmebeinganincrediblygenerousperson.Come tofindout,everyownerthinkslikethis.Inactualityitwasnot anactofgenerosityorloyaltyonmypart.Itwasmydesireto createthesimplestexitstrategywherebyIcouldgetthepriceI wantedforthebusinesswithoutanynegotiations.

Sadly,oncetheexcitementofbuyingmycompanyworeoff, mymanagerrealizedhedidn’thavethemoneyortheintestinal fortitudetorunan$8millionbusinesswith30employees.He subsequentlydeclinedmyoffer,andafewmonthslaterhequit becausehefeltthathehadfailedinmyeyes.Iwasmoredisappointedinthisdecisionthanhewas;IlostthebestemployeeI everhad.

Overthelast18yearsIhaveworkedwithhundredsofbusinessownerswantingtoselltheirbusinesses.Ifoundthatthe majorityofthemapproachedtheirmanagersfirst.Notonly werefewownerssuccessful,butamazingly,mostreportedthat theirmanagersubsequentlyquitaswell.Inmanyofthosecases wheretheownerandmanageractuallyreachedanagreement, thebankappraisalfortheacquisitionloancameinsignificantly lowerthanthesellerwanted,thuskillingthedeal.Theowner neverconsideredgettinganappraisalforthebusiness.Theaskingpricewasbasedontheamountneededforretirement,not whatthebusinesswasworth.

Thesecondmistakesellersfrequentlymakewhenselling theirbusinessesmayappeartohavelittletodowiththevalue ofthebusinesses.However,Imentionitbecauseownersshould approachthischoicewithextremecaution.AfterIwasunsuccessfulsellingmybusinesstomymanager,Ifeltthatoneofmy competitorswasthenextmostlogicalsuitor.Inretrospect,it wasmydesiretocreatetheeasiestexitstrategyandmaximize mysellingprice.Thecompetitorwouldcertainlybeawareof themanystrengthsofmybusiness.Inaddition,therewould notbeaneedfortraining,thus,providingmewithaquickexit. Theownerwouldalsowantmybusinesssobadly,heorshe wouldpayanyamountthatIasked,and,ofcourse,theowner

hadthedeeppocketstopaythatprice.Again,theactualvalue ofthebusinessdidnotenterintomydecision.

Theresultofmydecisiontoapproachmycompetitorturned outtobetextbook—I’veseenithappenmanytimesoverthe last18years.Itneveroccurredtomethatthereareunscrupulousbusinessownersoutthere.Themanagerofmycompetitor knewItookMondaysoff.Hecameintothestoreonmyday offandpassedoutbusinesscardstoallmyemployees.Hetold themthatwhenIsoldthestore,thebuyerwouldbesostrapped withdebtpaymentstheywouldnotgetpayraisesforyears. Theirbestchoicewastocomeworkforhim.Themanagerthen senthissalesforceouttoallmycustomersandtoldthemthat Iwasleavingandhewasnowthebestchoiceofsuppliers.I lostemployeesandcustomers,whichimpactedthevalueofmy business.

Justmakesurethatwhenyouapproachacompetitor,have himorhersignanon-disclosureagreementthathassignificant penaltiesfortalkingtoyouremployees,customers,suppliers,or othercompetitors.

Inaddition,nomatterwhothepotentialbuyermaybe,ask apricethatisfairandreasonable.Buyersarenotdumb.Ifthey feelthattheaskingpriceisnotreasonable,theywillnottryto negotiate.Theywillsimplywalkaway.Youwillcall,text,and email,butbelieveme,theywillnotrespond.Youwillhaveno ideathatthereasontheystoppedcommunicatingwasthatyour pricewastoohigh.Asabusinessbroker,Ihaveseenthishappen hundredsoftimes.

Hence,oneofthemainconcernsofallbusinessowners shouldbe,“Whatismybusinessworth?”Asabusinessowner, IreliedonbusinessbrokersandCPAsforinformationonthe valueofmybusiness.Asabusinessbroker,themostcommon questionIwasaskedwas,“Whatisthemultiplierformy business?”Theassumptionofmostbusinessownersisthata singlemultiplierexistsforhisorhertypeofbusinessthatcan beappliedtoitslevelofprofitsinordertodeterminethevalue ofthebusiness.Theassumptionfollowsthatasanappraiser,I

canmerelyopenatextbookonbusinessmultipliersandgive theownerananswerinafewseconds.Ifbusinessappraisals werethatsimple,wewouldallbeoutofworkandWallStreet wouldbenonexistent.

Aftermanyyearsofresearchonthesubject,Ifindthatevery businessisuniqueandwillhaveitsownsetofmultipliers.Those multipliersarederivedfromthecompany’slevelofprofitabilityandrevenue.Hence,Iamincreduloustofindbusinessbrokersandbusinessconsultantswhoofferupmultiplierstotheir clientswithoutevenknowingwhatthecompany’slevelofrevenueandprofitsareandhowtheycomparetothecompetition.

Unfortunately,thereareafewindustrytextbooksonrules ofthumb,whicharecollectionsofthousandsofbrokers’opinionsofthemultipliersforhundredsofbusinessclassifications. These“rulesofthumb”booksareusedextensivelybybrokers toestimatethevalueoftheirclient’sbusiness.Thetextbooks, however,shouldnotbeusedasasubstituteforaquantitative businessanalysisandvaluation.Todosowouldquitepossibly over-orundervalueabusiness10to20%.Foramillion-dollar business,20%isasignificantsumofmoney.Ifthebusiness isovervalued,itmayresultinanunsuccessfulattempttosell thebusiness.

ThesaddestcaseinwhichIwasinvolvedwasabusiness whereanunseasonedbusinessbrokerhadrecommendeda $1millionlistingpricebasedonsomeruleofthumb.The ownerswereacoupleintheir70swhowantedtoretire. Afterwastingayearandahalfwaitingforanofferthat nevermaterialized,theycalledonmetovaluethebusiness. Ideterminedthattheirbusinesswasworthonly$500,000.The couplewasconvinced(orshouldIsay,hoped)thebrokerwas rightandrefusedtoacceptmyopinion.Theyspentanother yearandahalftryingtosellthebusiness.Duringthattime,the husbandpassedawayandthewifeultimatelysoldthebusiness forroughlywhatIhadappraisedit.Thecouplewastedover threeyearsandnevergottoenjoyretirementtogether.

PEERREVIEWINGTHEREGRESSIONMETHODOLOGY

AquestionIfrequentlyamaskedwhenpresentingmyregressionmethodologyis,“WillthisprocedurepassaDaubertchallenge?”ADaubertchallengeisahearinginacourtoflawin whichthevalidityandadmissibilityofexperttestimonyischallengedbyopposingcounsel.Evenifthemethodusedbythe expertappearstobescientificallysoundandreasonable,the factthatithasnotbeenvettedbytheindustrypeersmaylead toitbeingthrownoutofcourt.

Iamnotanattorneyorajudge,butmyresponsewould be,“Yes,mymethodologywouldsurviveaDaubertchallenge.” Duringthelasteightyears,Ihavewrittenover400appraisals usingtheregressionmethodology.Halfthosevaluationswere forpartnershipsplitsordivorces,manyofwhichinvolvedcontentiouspartnersandtheirattorneys.Ihavesubmittedover100 appraisalstoeightdifferentbanksinnorthernCaliforniafor theirSBAloans.Ihavealsosubmittedadozenvaluationstothe IRSforestatevaluationsorgiftingpurposes.Outofallthose valuations,Ihavenotreceivedasinglecrediblechallenge.As youwillseelaterinthisbook,themethodologyissocompelling thatitisdifficulttofindanissuetochallenge.

Moreimportantly,myregressionmethodologyhasbeen publishedinmostoftheindustry’sleadingtradejournals including:

IBA’s(InstituteofBusinessAppraisers)“Business AppraisalPractice,”secondquarter2012 BusinessValuationResources–“Bestof2012—What’s ItWorth?”

NACVA’s(NationalAssociationofCertifiedValuators andAnalysts)“ValueExaminer,”July2016 Thomson-Reuter’s“ValuationStrategies,”July2016

NACVA’s“QuickRead,”January2018

IhavealsopresentedthemethodologyatfiveNACVA nationalconferences:June2016,December2017,June2018, June2020,andAugust2020.

Lastly,inJanuary2017JimHitchnerreviewedmymethodologyinhisannual“CurrentUpdatesinValuations”andgaveit “twothumbsup.”Mr.Hitchnerisoneoftheindustry’sleading educators.

WHYISN’TEVERYONEUSINGTHISMETHODOLOGY?

Averygoodquestion!Appraisersareslowtochangetheir methodologiesespeciallywhenthenewonesarenotan“easy sell.”Forexample,anexpertcanstandinfrontofajuryand statethatheorsheusedthemedianrevenueandcashflow multiplierstodeterminethevalueofthesubjectbusiness.He orshewouldgoontosay,“Medianisthemeasureofcentral tendencythatshowsuswherethemarketis.”Everyonehas beenexposedtotheterm“median”asitisusedextensively intherealestateindustry.Hence,theentirejurypanelwould benoddingtheirheadsupanddowninapproval.However, iftheexpertweretostandinfrontofthejuryandstatethat “Regressionistheroot-mean-squaremeasureofdispersion aboutthe ...,”everyonewould immediatelyfallasleep. Unfortunately,thereareafewjudgesouttherewhoconsider regressionas“voodoostatistics.”

Regressiononthesurfaceisaverycomplexstatisticaltool. WhenIwasinmyMBAprogram,Ienrolledinanadvanced forecastingeconomicsclass.(Thiswasbeforepersonalcomputersandcopymachineswhendinosaursroamedtheearth.)On thefirstdayofclasstheteacherwalkedinwithalargebinder underhisarmandannouncedthatwewereallgoingtolearn regressioninhisclass.Thechalkboardatthefrontoftheclassroomwas20feetwideandthechalkboardonthesidewallwas also20feetwide.Heproceededtowritetheformulaforlinearregressiononthechalkboard.Itcompletelycoveredboth

chalkboards.Ispentthenextthreemonthsintheuniversity’s computerlabtypingtheformulaonpunchedpaperIBMcards.

Luckily,todaywecanaccomplishthesametaskwithaclick ofabuttonwithMicrosoftExcel’sregressionutility.Inseveral chapterswewillgothroughallthestepsonemusttaketo useExcel’sregressioninmymethodology.Moreimportantly, Iwillbreakdownregressionintoitsverysimplecomponents. Iwillproducechartsthataresocompellingthatanyonelooking atthechartwillrealizethatmediansare not themeasureof centraltendencyofwherethemarketis—regressionis.Hence, ifyouarefacinganopposingexpertincourt,youcaneasily discredithisorhermethodologybyshowingthesecharts.

IwillbespendingasignificantportionofthisbookdemonstratingExcel’sregressioninorderforthereadertoobtaina betterunderstandingofhowitworksandtobeabletoreplicate themethodology.However,attheconclusionofthebookIwill introduceatemplatethatwillaccomplishtheentiremethodologyinsecondswiththeclickofabutton.

Acknowledgments

NATIONALASSOCIATIONOFCERTIFIEDVALUATORS ANDANALYSTS(NACVA)

PortionsofChapter1andChapter2havebeenpublishedin NACVA’s“TheValueExaminer”intheJuly/August2016issue, p.16.PortionsofChapter8havebeenpublishedinNACVA’s “QuickRead,”intheJanuary2018issue,p.5.

PortionsofChapter1andChapter2havebeenrecordedin nationallytelevisedlivepresentationsatfivedifferentNACVA conferences:June2016,December2017,June2018,June2020, andAugust2020.

NACVAhasgrantedtheauthorandJohnWileyandSons, Inc.permissiontopublishtheabove-mentionedmaterialin thisbook.

INSTITUTEOFBUSINESSAPPRAISERS (IBA,ASUBSIDIARYOFNACVA)

PortionsofChapter1andChapter2havebeenpublishedin IBA’s“BusinessAppraisalPractice”intheSecondQuarter2012 issue,p.18.

PortionsofChapter8havebeenpublishedinIBA’s“BusinessAppraisalPractice”intheFirstQuarter2014issue, p.15.

NACVAhasgrantedtheauthorandJohnWileyandSons, Inc.permissiontopublishtheabove-mentionedmaterialin thisbook.

THOMSON-REUTERSCORPORATION

PortionsofChapter1andChapter2havebeenpublishedin Thomson-Reuters’“ValuationStrategies”intheJuly2016 issue,p.30.

Thomson-ReutershasgrantedtheauthorandJohnWiley andSons,Inc.permissiontopublishtheabove-mentionedmaterialinthisbook.

BUSINESSVALUATIONRESOURCES,LLC(BVR)

PortionsofChapter1andChapter2havebeenpublishedin BVR’s“WhatIt’sWorth”intheApril2012issue,p.1and reprintedintheJuly2012issue,p.30.

BusinessValuationResourceshasgrantedtheauthorand JohnWileyandSons,Inc.permissiontopublishtheabovementionedmaterialinthisbook.

CurrentMethodologies

TheGuidelineCompanyTransactionMethodisasubsetof theMarketApproachandisasistertotheGuidelinePublic CompanyMethod.Thetwomethodsarecharacterizedby thetransactionaldatabasesusedinthecalculationofvalue. TheGuidelinePublicCompanyMethodusesvariousSEC (SecuritiesandExchangeCommission)dataofpubliclytraded companiesthathavebeenacquiredbyotherpubliclytraded companies.Thismethodisobviouslyusedtovaluelarge-sized publiclytradedcorporations.TheGuidelineCompanyTransactionMethod,whichwillbeusedinthisbook,referencesa numberofsubscription-baseddatabasesthathaverecordedthe salesofsmallprivatelyownedcompanies.Thedatafromthose transactionsiscomparedtothesubjectcompanyinorderto drawaconclusionofitsvalue.

Thefocusoftheregressionmethodologybeingpresentedis primarilyoncompanieswithrevenuelessthan$5million.Most ofthosetransactionshavebeenhandledbymainstreetbusiness brokers.Mostofthesebusinessbrokershavebeenschooled bytheIBBA(InternationalBusinessBrokersAssociation)and therefore,presentthetransactionaldatausingthesameformat.Ascompaniesincreaseinsize,especiallythosewithrevenuesgreaterthan$10million,M&Aspecialists(mergersand acquisitions)arethemorecommonsalesagents.Theselarger companiesarereferredtoasmiddle-marketbusinesses—bigger

thanmainstreetbutsmallerthanWallStreet.TheM&Aprofessionalsanalyzefinancialstatementsdifferentlythanmainstreet brokers.ForthemostparttheyuseEBITDA(EarningsBefore Interest,Taxes,Depreciation,andAmortization)asameasure ofearningsratherthanSDE(Seller’sDiscretionaryEarnings). Thetwovaluesaresignificantlydifferentasaretherulestocalculatethem.

ThetermsSeller’sDiscretionaryEarnings(SDE)andcash flowwillbeusedinterchangeablythroughoutthisbook. Thereareseveraltransactionaldatabasesavailablethat concentrateonthesmallermainstreetbusinesses.Thefour databasesreferencedinthisbookare:

1. DealStats(formerlyPratt’sStats)hasover30,000transactions.Themedianrevenueofallthetransactionsis $750,000.75%generatedlessthan$3,500,000inrevenue. Mostofthedataisobtainedfrombusinessbrokersubmissions.However,formanyofthelargertransactionsthedata washarvestedfromSECfilingsof8-Kquarterlyfinancial reports.ThedatabaseisownedandmanagedbyBusiness ValuationResources,LLC,Portland,Oregon.

2. Bizcomps® hasover14,000transactionswithamedianrevenueof$455,000.75%generatedlessthan$915,000in revenue.Allthetransactionaldataisobtainedfrombroker submissions.ThedatabasewascreatedbyJackSandersand isownedbyBizcompsServices,LasVegas,Nevada.

3. ValuSource(formerlyIBA)hasover42,000transactions withamedianrevenueof$341,000.75%generated lessthan$766,000inrevenue.Alltransactionaldatais obtainedfrombrokersubmissions.Thedatabaseisowned byValuSource,ColoradoSprings,Colorado.

4. Peercompshasover10,000transactionswithamedianrevenueof$1,034,000.75%generatedlessthan$1,890,000 inrevenue.DataisobtainedfromSBAlendingbanks.The databaseisownedbyPeercomps,Inc.,Lutz,Florida.

AnotablefifthdatabaseisValuSourceM&AComps (formerlyDoneDeals),whichprovidestransactionsinthe private-sectormiddle-market(companieswithrevenuesfrom $10millionto$300millionormore).Mostofitstransactions aremuchlargerthanthe$3to$5millionrangeoftheother fourdatabases.Theregressionmethodologyadvancedinthis bookhasnotbeentestedonthislargerpopulationofprivately heldbusinesses.

Eachofthefourmaindatabasesreporttransactionaldata inslightlydifferentformats.However,theretypicallyisenough datatoreconcileeachtransactiontoyieldasellingpricein anassetsalevalueformat.Anassetsaleisthemostcommon structureinwhichsmallbusinessesaresold.Theowneronly sellsthecompany’sinventory,fixturesandequipment,and itsintangibles(goodwill,covenant-not-to-compete,etc.)and retainsthebusinessentity,cash,andaccountsreceivableand paysoffalltheliabilities.

Eachtransactionusedintheregressionmethodologymust bereconciledtoanAssetSaleValuesothattheywillbedirectly comparable.

Theproceduralmanualsofthefourdatabasesalsoindicate minordifferencesinthewayrevenueanddiscretionaryearnings arereported.DealStatscollects165datapointsforeachtransactionincludingasummaryoftheP&Landbalancesheet,a descriptionofthetermsofthedeal,thetypeofconsideration tendered,andwhetheritisastocksaleoranassetsale.Because oftheextensiveinformationavailable,reconcilingSeller’sDiscretionaryCashFloworreconcilingtheactualsellingpriceof thetransactionisoftenmorereliable.DealStatscalculatesSDE similarlytoBizcompsandValuSource;however,itisnotuncommontofinddiscrepanciesamongallthree.Carefulanalysisof allthedatabaseswillhelpavoidselectingincorrecttransactional data.ThegreaterdetailofferedbytheDealStatsdatabasecan helpreduceerrorsinselectingthetransactionaldata.Therefore,

ifthereareanydiscrepanciesarisingamongduplicatetransactionsreportedbythedatabases,theDealStatsdatawillgenerallybeusedintheanalysis.

Nevertheless,ininstanceswherethedatabasesreportedthe sametransaction,Ihavefoundthatinahighpercentageofthe casesthesellingprice,grossrevenues,anddiscretionaryearningsweresimilar.Ininstanceswherethereweredifferences,the availabledataoftenenabledonetoreconcilethevaluestobe comparable.Onecanattributethissimilaritytothefactthat thesamebrokerswillreportatransactiontoallthreedatabases (Peercompsonlyusesbankdata)andwillofferonlyonecalculationforsellingpriceandSeller’sDiscretionaryEarnings(SDE). Brokerswilltypicallyfollowtheconventionrecommendedby theIBBA(InternationalBusinessBrokersAssociation)forcalculatingSDE.Therefore,allofthedatabaseswillbeconsidered similarenoughintheirrespectiveconstructiontobegrouped together.ShannonPrattdrawsthesameconclusionin TheMarketApproachtoValuingBusinesses. 1

“Onemaycombinethedatafromthethreedatabases intoasingletable. [However,] theanalystmustbeaware ofandmakecertainadjustmentstoreflectthatthethree databasesdonotdefinetheunderlyingfinancialvariables inexactlythesameway.”

Thismethodisasimpleratioofacompany’ssellingprice dividedbyitsgrossrevenues.Companieswithinaspecific industryclassificationhaveatendencytoexhibitsimilar relationshipsbetweentheirrevenuesandsellingprice.Selling

1 ShannonPratt, TheMarketApproachtoValuingBusinesses,Hoboken,NJ:John WileyandSons,2001,p.68.

priceandgrossrevenuesofacompanyarereadilyobtainable, makingthismethodeasytoapply.However,itdoesnot considerthecompany’sprofitabilityorassetvaluationin theequation.Therefore,thismethod,ifusedbyitself,may produceamisreadofacompany’spotentialvalue.Themethod alsodoesnotconformtoIRSruling59-60thatstatesone’s methodologiesmustbebasedoncashflow.

CashFlowMultiplier

Thismethodistheratioofacompany’ssellingpricedivided byitsSeller’sDiscretionaryEarnings(SDE).Itshouldbenoted thatthedatabasesourcesusedintheGuidelineCompany TransactionMethodcalculateearningsdifferentlythanthe waywecalculatednetcashflowintheIncomeApproach.SDE iscalculatedbyremovingoneowner’ssalaryandperquisites (suchashealthandpensionbenefitsorpersonalautos)from expenses.Interest,depreciation,incometaxes,anyone-time expenseorincome,andanynon-operatingexpenseorincome arealsoremovedfromtheincomestatement.Theprocess ofcalculatingSDEfromacompany’sfinancialstatementsis referredtoas“recasting.”Recastingwillbediscussedindepth inthefollowingpages.

However,oneofthesameproblemswiththegrossrevenue multiplierexistswiththecashflowmultiplier.Thatis,theratio onlyfocusesononeaspectofthecompany’soperations—its discretionaryearnings.Therefore,ifusedbyitself,thisratio mayproduceamisreadofthecompany’svalue.Forthatreason,theMarketApproachtypicallyincludesboththecashflow andgrossrevenuemultiplierstoestimatethevalueofabusiness.

EnterpriseValue + Inventory

Undercertaincircumstances,however,usingtheearliertwo methodologiescanstillproduceinaccurateresultswhen valuingbusinessesthatderivethebulkoftheirrevenuesfrom thesaleofinventory.Forexample,itwasdeterminedthatthe averagehardwarestoresellsfor0.45timesitsgrossrevenue

and3.30timesitsSDE.Inoursearch,wefindtwoguideline companies,eachgenerating$900,000ingrossrevenuesand $125,000inSDE;yetonesoldfor$400,000andthesecond for$600,000.Theanomalycanprobablybeexplainedbythe factthatthefirststorehad$200,000ininventorywhilethe secondhad$400,000.

Theenterprisevalue + inventorymethodologydeductsthe volatileinventorycomponentfromthesellingpriceofthebusiness.Thedifferenceisthendividedbythecompany’sSDE.The resultingratiocanbeusedtodeterminewhatisreferredtoasthe enterprisevalueofthebusiness;thatis,thevalueofabusiness excludingitsinventory.Byusingthismethodologyonthetwo transactionsabove,wefindthatenterprisevalueforbothbusinesseswas1.60[Store#1 = ($400,000–$200,000) ÷ $125,000; Store#2 = ($600,000–$400,000) ÷ $125,000].Wecanthen usethisratiotoestimatethevalueofathirdhardwarestore thatgenerated,say,$1,450,000ingrossrevenues,$200,000in SDE,andhad$375,000ininventory.Store#3’senterprisevalue is$320,000($200,000 × 1.60);itstotalvalueincludinginventoryis,therefore,$320,000 + $375,000,or$695,000.Thecash flowmultiplierbyitselfwouldhavepredictedonly$660,000 (3.30 × $200,000)andthegrossrevenuemultiplierwouldhave predicted$652,500(0.45 × $1,450,000).

Whenreconcilingtheabovethreemarketvaluemultipliers toestimatethevalueofthisthirdhardwarestore,wemightconsidergivingadditionalweightingtotheenterprisevaluebecause thisstoreprimarilygeneratesitsrevenuefromthesaleofinventory.

Recasting

The“recasting”ofacompany’searningsservestwopurposes. First,thedatabasesweuseforcomparablesareacollectionof allformsofbusinessentities:Scorporations,Ccorporations, LLCs,partnerships,andproprietorships.Hence,weneedto stripawaythedifferencesinaccountingmethodsusedbyeach

ofthosedifferententitytypesinordertomakethemdirectly comparable.Forexample,soleproprietorships(SP)report earningsontheScheduleCoftheowner’spersonaltaxreturn. Thereisnoowner’ssalaryexpenseinanSP;the“bottomline” representstheowner’stotalincome,andpayrolltaxesforthat incomeappearsontheowner’s1040.However,corporations andpartnershipsgenerallyincludeadeductionforanowner’s salaryexpenseincludingpayrolltaxesonthatsalary.Thus,the bottomlinefortheseentitiesisnetoftheowner’ssalaryand payrolltaxes.Tomakethecorporatetaxreturnearningsline upwiththeSP,wewouldhavetoaddbacktheowner’ssalary andpayrolltax.

HealthbenefitsareadeductioninCcorporationsbutnotin SPs(benefitsappearontheowner’s1040).Manyaccountants alsodonotincludeowner’shealthbenefitsinScorporations, optingtodeductthemontheowner’s1040taxreturn.DonationsareusuallyadeductioninCcorporationsbutoftennot inScorporations(donationsfrequentlyappearontheowner’s K-1).Accelerateddepreciation(IRCSection179)andgains orlossesfromthesaleofassetsoftendonotappearonanS corporationtaxreturn(theyoftenappearontheowner’sK-1) butdoonaCcorporationoronanSP.Stateincometaxesdo notappearonanSPbutdoonacorporation.SPsbydefinition haveoneowner,whereascorporationsandpartnershipsmay havemultipleowners,allwithsalariesthatareexpensed, therebyreducingthebottomline.Finally,sinceinterestexpense canvarygreatlybetweensimilarcompanies,makingdirect comparisonsofearningsisdifficult.Thus,itisalsocommon practicetoremoveinterestexpensefromtherecastfinancials.

Inordertodevelopsomemeasureofearningsforallthese differententitiesthataredirectlycomparabletoeachother,the databaseshaveremovedallthoseaccountingdifferencesfrom theirincomestatements.Accordingly,eachentity’sreported “earnings”isnetoftaxes,depreciation,healthbenefits,donations,capitalgains,interestexpense,andmostimportantly, netofjustoneowner’ssalaryandpayrolltax.Theresulting

measureofearningsisreferredtoas“Seller’sDiscretionary Earnings”(SDE).

Ifacompanyhasmultipleowners(includingworking spousesofowners),thesalaryoftheprincipalownerwho wouldmostlikelybereplacedbyahypotheticalbuyeris addedbacktodiscretionaryearnings(SDE).Itisalsoassumed thatthehypotheticalbuyerwouldhavetoreplaceallthe secondaryownersorfamilymemberswithhiredemployees. Consequently,allowners’andfamilymembers’salariesare addedbacktoSDE,butthereplacementcostsofthesecondary ownersandfamilymembersare deducted fromSDE.

Ifthepresentownerisanabsenteeowner,thesalaryofthe generalmanagerisaddedbacktoSDEalongwiththeowner’s salary.Theassumptionhereisthatahypotheticalbuyerwillbe afull-timeoperatingowner/manager,therebyreplacingboththe managerandtheowner.Indoingsohewillearnthemanager’s salaryandtheowner’ssalary.

Afterapplyingalltheaboveappropriateadjustments,we canthendirectlycomparetherecastSellersDiscretionary Earningsofcorporationstosoleproprietorships,partnerships, andsoon.(Theterms“Seller’sDiscretionaryEarnings”and “cashflow”areusedinterchangeablyinthefollowingMarket Approachdiscussion.)

Thesecondpurposeforrecastingacompany’searningsisto attempttopresentanormalizedviewofthesubjectcompany’s operations.Therecastfinancialsshouldserveasaproxyforthe levelofoperationsfromwhichwemayreasonablyexpectfuture revenuestoevolve.Thus,weselectanearningsperiodthatbest representsthecurrentlevelofoperations(whichmaynotbethe currentyear’sP&Ls),andthenweremoveanynon-operating incomeorexpensesandanynon-recurringincomeorexpenses. Theresultshouldbeanincomestreamforthesubjectcompany thatwecanreasonablyexpectundernormalcircumstances.The normalizedP&Lofthesubjecthasnowbeenproperlyrecast andcanbecomparedtothedatabaseguidelinecompanies.

ConventionalAnalysisofaSampleofComparables

Afterasampleoftransactionshasbeenselected,thetypical approachistousevariousstatisticalmeasurestocalculate theappropriatemultipliersthatwediscussedpreviously. Exhibit1.1showsasampleoftransactionswiththerevenue andcashflowmultiplierscalculatedforeach.Atthebottomof thetable,threedifferentmetricswereusedtocalculateappropriatemultiplierstobeappliedtothesubject’srevenueandcash flowtodeterminetheestimatedvalueofthebusiness—lower quartile,median,andupperquartile.2

OneofthecurrentpopulartopicsregardingMarket Approachmethodologiesiswhetherthemedianortheharmonicmeanisthebetterstatisticalmeasuretocalculatethe revenueandcashflowmultipliersofasampleofcomparables. Bothmetricshavetheirstrongpoints.However,themultipliers theygenerateoccasionallyproducevaluesforanappraisal subjectthatdonotappearreasonable.Itisfairlycommonthat thevaluecalculatedusingthemedianrevenuemultiplierofa sampleofcomparablesisconsiderablyhigherthanthevalue calculatedusingthemediancashflowmultiplier.And,atother times,wefindthatthevaluecalculatedusingthemediancash flowmultiplierisconsiderablyhigherthanthevalueusingthe medianrevenuemultiplier.

TheProblem

Wewillstartwithatypicalsampleofcomparablesthatan appraisermightcollect.Exhibit1.1shows24companiesthat weresimilartooursubjectcompany.

Eachtransactionshowsthesellingprice,grossrevenue, cashflow,anditscalculatedrevenueandcashflowmultipliers. Fromthedatawecancalculatethemedianrevenuemultiplier

2 Manyappraisersalsouseawiderrangeofrevenueandcashflowbycalculatingthe standarddeviationortenthpercentileofearningsandrevenue.

Valuing businesses using regression analysis c. fred hall all chapter instant download