Probably the most important yet most misunderstood discipline in acquisitions is valuations. Let me cut through the junk by offering up the most ludicrous valuation methods and at the same time giving you a few that make sense. When calculating the value of the small business one thing you need not do is take a multiple of sales and use it as a rule of thumb. Multiples of sales are pretty much meaningless unless you are buying a high tech dot.com bubble company or something like a motel. Why are they meaningless? Well pretty much because the sales could be one number but the actual money you put in your pocket from profits is totally unrelated. A $1 Million sales company could generate $400,000 in profits or barely break even. Obviously your multiple of sales would come up with the same pie-in-sky number each time regardless of how lousy the profits are. Case closed. DCF is discounted cash flow. This makes slightly more sense – for a growth company perhaps. The problem is that DCF relies on future projections to generate a value. Picture a set of projections that run ten years into the future and then trying to boil it all down to today’s value. Mathematically it can be done but it gives the somebody the license to dream up the most optimistic projections imaginable. A small business has good years and bad. A DCF projection never has a bad year. Liquidation and Asset valuations. One can assign market value to all of a company’s assets and
add them up to find the value. While this makes some sense if the assets are to be sold separately, it does not take into account any going concern value of the enterprise. In other words it does not take into consideration the operating performance, or, you guessed it, profits. The not-so-ludicrous IRS method, aka capitalization of
excess earnings method is probably among the fairest of methods. It seeks to take into account both the earnings of a company and the assets. It assigns capitalization rates to the assets and the earnings. It also credits the company for its excess assets which many companies have. For example if a company had spare cash of say $500,000 which wasn’t needed for working capital, then that would be added to the valuation. I happen to use a combination of this
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method and the Rule of Thumb method which is simpler still. In the industry we generally use 2-5x multiples of earnings weighted mostly towards the current year. This takes the place of cap rates and provides a range of values depending on the relative merits and size of the deal. And if there are excess assets they could either get excluded from the deal or added to the valuation. This avoids a lengthy calculation of cap rates against assets and earnings. Yet it generally takes you to the same place except with often more conservative values. Note that we assume the earnings are calculated the same way across the board using EBITDA which deducts the compensation of all essential personnel (but not absentee owners for example). Keeping the calculation simple is the most efficient way to go because your valuation is going to be challenged 5 ways to Sunday no matter what.