Money is to be made during recessions, not in economic booms. Period. Warren Buffett, the legendary investor, made some of his best gains from buying during recessions. For instance, he bought Allstate insurance company in March, 2000, at a time when the insurance industry was going through a recession, which brought him hefty returns in the years to follow. The secret remains is how to properly value a business. This requires both investor and business acumen in evaluating, and valuating a business; an art in itself.
Evaluating 3C’s and 3P’s
Before valuating a business through a numbers crunching exercise, the buyer needs to evaluate the 3C’s of the business: company, customers, and competitors. In turn, by evaluating the company, the buyer needs to assess the 3P’s of the company: people, process, and products. In terms of people, the review should cover their character, reputation, experience in the business, and main reason for selling all or part of the business. Their management style is also important, assuming that some or all of the employees will be remaining with the new management, and should sense more progress and efficiency in the new management to come. In terms of process of the company, it is basically a description of how it does its business: its business model. It could be a merchant model, who is a retailer of products; a subscription business, collecting subscriptions; a broker, acting as a commercial intermediary; an information intermediary, like a consultant; or a community model, gathering people and selling advertisement to access their community. It is important in the assessment of this business model, whether the process is unique, or proprietary, or whether it can be easily copied with no added advantage to the original business. This reflects also on the product or service produced whether it is unique, or not, and what feature and benefits it provides for the price; its customer value.
It is essential to understand the customers of the business, since they are the ultimate drivers of the company’s profitability. The product or service of the company should appeal to large demographics of the customers, with a continuous demand and a significant market share. In comparison to its competitors, the business should be reviewed whether it is the price competitor, or the quality differentiator. Especially during weak economic times, quality as a deciding factor has taken a back seat to price sensitivity, and hence it is paramount for companies to be operationally efficient in this sense. A full market size, and customer demand may not be needed at this point, but rather a SWOT analysis (strength, weaknesses, opportunities, and threats), or Porters five forces of competitive position should be used as a guide.
Business valuation is more of an art rather than an exact science; price can be seen, but value can only be perceived. Nevertheless, there are three general business valuation approaches; an income statement approach, a balanced sheet approach, and a miscellaneous approach. The miscellaneous approach could be based on the last similar business sale, or it could be based on an owner benefit valuation which accounts for the salary and cash flow to the owner.
As for the balance sheet approach, this could involve a replacement valuation approach; how much would it cost to establish the company at today’s market prices. However, more often than not, it involves a discounted book value approach; a discounted valuation of the company’s assets on the balance sheet. This balance sheet valuation approach is often used for asset-intensive companies such as that in the industrial, or manufacturing businesses, as well as businesses whose assets are worth more than their running business, i.e. their liquidation value. It could also be on an intangible valuation of a company’s trademark, patent, or market reputation.
Nevertheless, for profitable businesses, the income statement-based approaches take the driver’s seat, especially for service-oriented businesses, with low fixed costs. In this case the norm is to determine the business value by multiplying the annual sales with a risk-adjusted industry multiplier that is often between 0.25 and 1. The adjustment to the industry multiplier is according to factors such as the perceived risk, market share, client base, proprietary products, brand or a patent name. This also varies across industries; for example for restaurants the formula used is 30-35 percent of sales + inventory, whereas for grocery stores the value would be 15 percent of sales + inventory. Another method is to value the company by multiplying cash flow or EBITDA (earnings before interest, taxes, depreciation and amortization) with a multiplier between 2-12 times. The multiplier often used in this case is between 2.5 and 4.5 because this represents the number of years for the buyer to return his capital. For instance a multiplier of 3 would have an approximate 33.3 percent annual return, and a capital payback period of 3 years. This also varies across industries; for example the EBITDA multiple for real estate agents is 2, whereas for a publishing company it is 10. (Editor’s note: You may contact the author for a table on the sales, and EBITDA multiples valuation of several industries).
Another income statement-based valuation approach is the income capitalization method. This involves determination of the capitalization rate, which is the rate of return required to take on the risk of operating the business – the riskier the business, the higher the required return. Earnings are then divided by that capitalization rate to determine the value of the company. The difficulty remains to determine the capitalization rate, which should be a risk-adjusted industry capitalization rate. A full-fledged discounted cash flow model can also be made which discounts the future projected earnings of a company by this capitalization rate. A proper valuation also considers a full assessment of the types of risks: hazard, financial, operational, and strategic risks.
The Why Factor
The last economic downturn has forced many small businesses towards change and adaptation. Part of this change is adding partners in the business, or outright sale of the business. However, it is paramount to understand why the seller is selling, and why the buyer is buying. Of course this affects the negotiations of the final price, but more importantly it determines the strategy of the business going forward. For instance, as a buyer, if your focus is a return on investment, then this would determine your strategy: you could be a vigilant cost-cutter, or a well-connected high sales generator and product developer. At this point there is no need to stall on the details, but a roadmap of resources to be available to achieve critical operational targets (such as efficiency), and financial targets (such as margins, and sales) would be useful. By mapping out process workflows in diagrammatic form, the future management can gain a clear understanding not only of how information flows and interacts within the business, but more specifically where it breaks down or relies on weak or ad hoc links.
Furthermore, in addition to the aforementioned operational review, and target setting, it is also important to review the capital structure of the business. For instance, a debt overhang in the structure can hinder equity holders from investing in positive net present value projects. This is because the benefit to debt holders would reduce the value created for equity holders.
In conclusion, ultimately value is the price that is paid to buy the business. However, buying a business requires review of several factors over and above the price paid all of which need to be considered. This is to ensure that when you buy the business you are able to run it, rather than the business running you.