Investment advisors often ask us “What’s my client’s company worth?” In corporate finance parlance they are asking: “What is the valuation of the business?”
There are several approaches to determining the value of a business, the most common being the Discounted Cash Flow model. This method discounts projected future cash flows to a present day value using a discount rate (estimated using the weighted average cost of capital).
If there is a legal requirement for a valuation (shareholder dispute, divorce, death, etc.) a professional valuator will use some variation of this methodology.
The problem with a DCF model is the requirement to forecast years of future cash flows and then assign a discount rate. A much more practical approach is to look at historical cash flow and put a multiple on a figure based on historical evidence. The figure that is calculated is normalized EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization), less maintenance capital expenditure.
What is normalized EBITDA?
EBITDA numbers come from the company’s income statement and should be reviewed for the past three-to-five years. In general we are looking for an average amount and the trend . An increasing EBITDA trend will push up your multiple, while a decreasing trend lowers it.
Normalizations refer to personal or non-recurring expenses that are put through a business to minimize earnings in order to decrease taxes. Common examples include spouses and relatives on the payroll who don’t actually work in the business, personal expenses such as vacations or cars, and so forth.
The normalizations are added back to the EBITDA to reflect the company’s true ability to generate future cash flow.
Depending on the company, these can be quite large. And if they are, this will jeopardize the sale of the business because the buyer will not want the potential tax liability in future. A buyer also will become suspicious of the financial reporting if the owner of the company is aggressive with normalizations.
So we would recommend that you advise any business owners you work with to try and minimize normalizations in the years leading up to a sale. Any increased taxes paid now will be offset many times over by the increased sales price.
Maintenance capital expenditures
That’s the annual capital expenditure required to maintain business operations. If the company has a lot of buildings, machinery or equipment that needs to be replaced or maintained, the annual amount of this cost must be deducted from the normalized EBITDA.
Once you’ve calculated a weighted average (the most recent years are more heavily weighted) of normalized EBITDA less maintenance capex (let’s call this EBITDA hereafter), you can then put a multiple on EBITDA to calculate a rough value of the business. Generally, multiples vary from three-to-six times EBITDA.
How to determine the multiple
Positive factors include: an increasing EBITDA trend over the past few years, an increasing revenue trend, recurring revenues that are consistent year-in and year-out, strong growth potential, natural barriers to entry and a good management team.
If the company depends heavily on the owner for future growth or operations, it will be less attractive to potential buyers.
So if a company has $2 million of EBITDA and is just holding its own, not growing but with steady cash flow, it’s safe to estimate it will be worth be four times $2 million: $8 million.
In some cases, a buyer may want to acquire that business because it’s essential to her strategic plans. In such instances, the price will be above any financial model an independent valuator would construct.
Likewise, if there’s some intangible negative hanging over the head of a company, such as a major lawsuit, the sellers could find themselves in a no-bid situation until the lawsuit settles.
The only way to determine the actual value of a business is to go to market well prepared, with a well researched and disciplined process and see what the highest bidder will pay.