I continue to see buyers, sellers and investors get confused by trying to apply rules-of-thumb valuation methods in trying to value a business in the current market. Well, things have changed, and many rules-of-thumb just don’t apply any more.
It’s important to note that valuation basics are the same – it all comes down to trying to figure out future cash flows, then figuring out a rate-of-return that a buyer wishes to enjoy from the cash flows. But when using a rule-of-thumb, such as applying a multiple to historical earnings – well, watch out.
Here are some common questions:
What Multiple of Earnings Should I Use Right Now?
One answer is: “Same Multiple”. A better answer is, “Multiple of What?”. A multiple of earnings is really a rule-of-thumb derived from many analysts and buyers looking at the cash flow (earnings) streams of companies and figuring out discounted cash flow, rate of returns analysis, etc. But the outcome was similar, and over time it became easier to apply a rule-of-thumb multiple to earnings than to create a model of cash flows. Those principals have not changed, and the “multiple” has not substantially changed (it does change a bit from the change in buyers expectations of rate-of-return).
So Do I Use A Three Year Weighted Average of Earnings, or What?
What do you apply the multiple to? This is the toughest number to come up with in this market. They key to this is understanding that the only reason you use historical earnings to apply a multiple to is when historical earnings reasonably predict the future. Because the future is really what matters. Obviously, things have changed for many companies and the past no longer predicts the future. IF that is the case, then it doesn’t make sense to use a five-year average, or a three year weighted average, or in some cases even the trailing 12 months. Throw it all out! You have to use some common sense here, because many companies continue to perform, and in that case it does make sense to look at the past.
OK, There are Currently Just a Tad of Earnings – Do I use that?
What do you think will happen in the future? I’ve seen companies where they have clearly lost momentum, lost key people and lost key customers. It would be difficult to believe that company is coming back without a lot of hard work and capital infusion on the part of a new buyer. In that case, a buyer would probably argue that they should not pay much at all for the company. On the other hand, there are companies that are clearly impacted by the economy, but which will likely bounce back when the recession eases. (In fact, many small and medium companies will be on the leading edge and will bounce back before the media starts talking about it.) In that case it is a negotiation, the age old dance between a buyer and seller, and now without rules-of-thumb to provide guidance. Fortunately, there are deal structures which help buyers and sellers come to an agreement in cases like this.
Earnings are Zero – What do I do Then?
Well, any multiple times zero is zero, and unfortunately that is the starting point. Then you have to look at the hard assets (equipment, vehicles, inventory, etc.) of the business. Statistics (and common sense) show that as earnings decrease, the fair market value of the hard assets play a more prominent role in the valuation, until finally that is all there is. A liquidation sale. eBay or the like.
But What About Customer Lists, Name– You Know, Goodwill?
Intangible assets are only as valuable as their ability to generate earnings. If they can’t generate earnings, they are not worth anything. Goodwill is defined as the difference between the total value of a business and the assets. In other words, there may be zero goodwill. HOWEVER, customer lists, websites, processes, etc. may be worth something to competitors and other strategic buyers. In other words, maybe the current company can’t generate earnings from its assets, but another company can – and will gladly pay for it.
How Do I Value Assets for a Strategic Buyer?
Let’s say a company has negative earnings, and the future looks grim. It does have some trucks, equipment, a decent international customer list, and top natural rankings in Google search. There are competitors in the space both in the
Getting multiple parties interested in the assets is the key, and it all comes down to the same techniques used to maximizing value for more typical companies in a normal market. If you get multiple companies interested, then natural competitive market forces will create the highest and best value. The buyer, if he has done his homework correctly, will still have plenty of margin left in the deal and will benefit from the transaction. The seller is much better off than liquidating the assets.
Getting it Done
For some sellers in this situation, it may be obvious there are only two other companies that would benefit from the assets. The action is simple – call them up. For others, like in the example above, there is benefit in bringing multiple types of strategic buyers to the table and doing a world wide search to find them. Woodbridge offers a program that does just this by executing a marketing program that is designed to find and engage strategic buyers for companies with little or negative earnings.