Football already has a head start with the new menstrual cycle paradigm. There is a pass protection scheme called max-protect. You can be the first to run up to my three hundred plus pound Redskins neighbor, Trent Williams, and tell him he should block like a super-absorbent tampon. Good luck with that. I'll stick with the war analogies.
Can you value your business by yourself? Let's look at a recent sample of DIY business valuation I experienced recently. I was asked to provide a business valuation for a small government contracting firm. After a couple day's work, I sent the owners my draft valuation. In the meantime, they decided to use an internet valuation service. Of course, we were really close on our numbers – of course not.
Here's how they came up with their valuation number. Their company's after tax cash flow was about $100K per year on annual revenue of $3 million. They were projecting next to no growth over the next few years given the uncertainty in the government contracting world caused by Congress's fantastic handling of the federal budget. Yes, that's sarcasm. So far, I have no problem with what they've done. They have accumulated their historical financial results and projected them reasonably into the future.
Next, they went searching for comparable companies in their industry that had been sold. No problem yet. Their search identified ten company sales in the government contracting industry. On average these companies sold for nine times annual cash flow. They took the multiple of nine times their annual cash flow of $100K and concluded their company was worth $900K. I should add that these guys are rocket scientists, literally. So math is their gig, and their math is correct. However, their business valuation is VERY wrong.
What's wrong with their analysis? They identified a multiple and applied it to the correct measure, cash flow. That's a hundred times better than most people do. However, when I asked for the listing of companies they used to determine the multiple of nine times cash flow, I saw that the annual sales for these companies ran from a minimum of $15 million to a maximum of $100 million. Just, how similar are these companies to their company? Not very. The smallest company they considered was five times their size.
Women are correct that size matters (it hurts me to write that), especially in the business valuation world. The valuation world consists of several distinct market segments divided by annual revenue. Those segments are divided into the following revenue categories: less than $5 million, $5 to $10 million, $10 to $25 million, $25 to $50 million, $50 to $100 million, and above $100 million. Valuation professionals will say I'm being overly simplistic. There are actually sub-segments within the segments. Each segment has its own valuation characteristics and cash flow multiples. Their analysis used a multiple from revenue segments way above theirs. That was the first mistake.
Their second mistake was not understanding what was really in the comparable sales statistics. Even if they had found sales in their segment, they used a multiple without understanding the numbers behind the multiple.
They took at face value the nine times cash flow statistic. Let's take a look at that cash flow multiple from an investor's viewpoint. Someone paying nine times after tax cash flow for a business is investing nine dollars for every dollar of annual profits. That is an after tax return of 1/9 = 11%. No one invests in a small business looking for an 11% return. Typically, investors look for something in the range of 20% or more after taxes.
That seems like a lot until you consider the risk investing in small businesses. You are as likely to walk away with nothing for your investment as you are to have any return at all. Some of you have tax loss carry forwards in the hundreds of thousands of dollars from bad investments. I feel your pain. Given your investment experience, are you going to invest $900K to get the possibility of a 10% return? Probably not. 20% probably isn't tempting you either. So you can see the nine times cash flow return of 11% just doesn't pass the laugh test.
Were the buyers of these businesses in the study stupid? No. Investors don't buy historical earnings. They buy future earnings. These businesses weren't paying nine times future earnings. They likely paid about five times future earnings. That's an after tax return of 20%. In evaluating their buy-out targets, the purchasers looked for growing companies or companies where the cash flow could be easily improved. The statistic of nine times historical earnings is a classic apples to oranges comparison. A purchase price based on future cash flow is used to compute a multiple based on past cash flow. That doesn't work very well. Even rocket scientists can screw up the math.
What was my valuation? About $300K. That looks like three times earnings and the end result is exactly that. But again the multiple is misleading until you look at the logic that resulted in the final valuation. If you value the company at a reasonable multiple of five times cash flow, you get $500K as the valuation. However, there is an inherent assumption in that price of a ready market for the company. There is no ready market for government contractors with $3 million in annual sales. In fact, there isn't much of a market at all.
First, large companies won't usually bother with really small acquisitions unless there is some really valuable proprietary technology. The expenses of acquisition are basically the same for buying a $30 million company as for a $3 million company. Also, small government contractors typically have contracts set aside for small businesses that large companies aren't allowed to acquire.
Second, the revenue stream of a small company is usually highly dependent on the personal relationships of the owners. If the owners leave, the revenue either stops or decreases significantly. In short, for small government contractors, there is a very small pool of potential buyers.
Based on the two factors above, I discounted the $500K value to $300K. Yes, that is 40%. In the business valuation world, this is called a discount for lack of marketability. A 40% number is not at all unusual.
You could conclude that I used a multiple of three times cash flow, and that is what the statistics would show. However, you can see that multiple would be misleading if you blindly applied it to other companies. Statistics don't lie. They just sometimes hide the underlying truth. Herein lies the problem with DIY valuations and the internet services. You have to know what is behind the statistics to intelligently apply them. Yes, valuation professionals, like me, laugh at the DIY'ers. Sorry.
Those wacky British royals are in the news this week for getting naked in public again. Yes, I know the photographer shot Kate from seven hundred yards away. The royals are apparently unaware of some technical advances that have occurred since Henry VIII started relieving his wives of their heads. There are these things called planes, helicopters, and telephoto lenses. If you are bare ass naked outside, someone can take a picture of you from somewhere – maybe even from earth orbit. Of course, I'm as interested in seeing Kate's Jim Dandies as much as the next horny guy. So if you have these pics, I'd love to take a look. Prince Harry – not so much. Although I would like an invitation to the next nude billiards game in Las Vegas. I promise not to bring my cell phone.
Thanks for reading! For real tax and accounting advice, please visit the main S&K web site www.skcpas.com. Until next time, let's do it to them before they do it to us.
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