By Maurie Cashman
Sales comparables present several problems when used to calculate value multiples and business valuation.
The Direct Market Data Method (DMDM) is one of the methods business valuators use to calculate the value of a business. It assumes that a buyer will not pay more for a business than what a comparable business would sell for. The three most popular databases that supply data on transactions are the Institute of Business Appraisers (IBA), BizComps and Pratts Stats.
Wide Range in Calculated Values
In commercial and residential real estate land and improvements can be measured fairly accurately using a comparison of price per square foot, making adjustments between comparable properties (comps) for specifically identifiable differences between the subject property and the comps. In Ag appraisals, comparable properties are adjusted for Crop Suitability Ratings and geographic location to calculate subject value.
Businesses are much more complex and have many variables that can have a significant impact on value. When attempting to value a company using DMDM, we often find a wide range in value between the price to earnings (P/E) and price to sales (P/S) ratios. When using transactional data we are comparing business sales. These are complex entities and transactions.
Issues with Comparable Data
Why do we get wide ranges between multiples when using comps? The databases obtain their data mainly from business brokers and other intermediaries. There are no standardized reporting systems and details of transactions are often limited. Business sale structures can be very complex and it can be difficult to communicate and capture all of the intricacies of a negotiated business sale. Many sales contain exchanges, earnouts, seller financing, employment and non-compete agreements or price adjustments based on contingencies. It is difficult to capture enough detail to properly convey all of the components affecting the price. Auditing functions are generally not robust. Finally, individual parties with widely varying competency levels negotiated each sale. The skill of the negotiator could have a significant impact on the value achieved in a particular sale.
Inventory Value and Accounts Receivable
- Is inventory included or excluded from the sale price? Some databases remove inventory from the selling price, some include it. Sometimes it is noted in the transaction and sometimes not, or no value is included.
- How do we know that the inventory is correct?
- Is it based on a physical inventory?
- Was there old or obsolete Inventory excluded or discounted?
- Was inventory accounted for on a LIFO or FIFO basis?
- Was inventory accounted for at cost?
- Did the buyer and seller agree on a value for inventory that was different than reality when they allocated purchase price in the purchase agreement?
Similarly, Accounts Receivable receive different treatment in nearly all sales. Sometimes it is included in sales price. Sometimes the buyer will purchase only current receivables and leave the rest to the seller to collect. Sometimes there if a variable structure flowing receivables through to the seller if the buyer collects it. If AR is a significant part of invested capital, this can have a major impact on transaction value.
Location, Location, Location
Real estate and improvements are not included in reported transactions, instead a “fair market rent” is deducted from the company’s earnings. How can we know that the rent used is fair market? The location given is generally limited to state and sometimes is a region. This could have a significant effect on value for some businesses if location is critical to success. In other cases, sales with high multiples may be misleading. The business may have been purchased based on acquiring a valuable territory or eliminating a major competitor.
I once sold a manufacturing business that generated a mid-teens EBITDA multiple based on the quality of a facility and the territory controlled by my client. We located a buyer that was willing to pay a premium based on the strategic nature of the purchase and the available synergies.
The Relative Position of the Buyer and Seller
- Was the transaction reported an arm’s length sale?
- Was part of the value gifted to a son or daughter when the parent retired?
- Did the seller employ a tax-reducing strategy to limit or defer capital gains taxes, significantly lowering the reported transaction value?
- Did the seller wait too long to sell – generating a situation where buyers knew they did not have to pay fair-market-value?
- Did one of the parties recently lose or gain a major contract with a key customer?
- What if the key people got wind of a pending sale and headed for other pastures at the last minute?
The historical performance of a business can have a major impact on both its value and the multiples reported on transactions. Multiples are generally reported based on the most recent year’s performance. If the company reported abnormally good sales or earnings in its last year before the business is sold, it might show a low EBITDA multiple. If sales/earnings dropped off for some reason that transaction might generate a very high multiple.
This valuation also does not take expectations of the future properly into account. One does not know how buyers and seller were feeling about the prospects of a business at the time of the comparable sale. Perhaps the industry was in a down cycle at the time of the sale and now is anticipating clear sailing ahead.
Often there are only a few transactions, if any that are truly comparable to the subject. A sale from New York may not be comparable to one in Iowa. Neither is a sale that took place in 2010, just after the economic crash comparable to one that took place in 2016. If the valuator is not skilled and experienced this information can be used inappropriately to generate a value that is not supported.
The 2018 Tax Act
Business taxes were significantly reduced beginning January 1st. All “comparable” transactions were completed under the old tax rules. Do you think that reducing taxes by 45% might have some impact on the value of a business or on earnings multiples?
We have experienced a period in which volatility on almost every front has been low. Interest rates have been stable at low rates. The stock market has been climbing at an unrelenting pace. Confidence is high. All of these things must be considered when comparing to historical transactions.
Is It Valuable?
Comparable company data is certainly valuable in comparing performance metrics. It must be carefully considered however, when it is used to generate valuation. I don’t recall ever using comps alone to generate a value. It has some value as a sanity check against value calculated utilizing other methods. Be very cautious of valuations based solely on comps, rules of thumb or earnings multiples.
Don’t leave huge chunks of the value you have built or are acquiring on the table. You will get a huge return on investment by hiring an experienced and skilled valuation expert to support your transaction theory.
© 2018 Aspen Grove Investments, Inc.