A Basic Guide for VALUING a Company phần 6 pot

In this particular business, we must note that $92,155 of currentassets are sales promotion devices that are unlikely to be turned back intocash per se.sig-Total Current Assets Total Cur

service its obligations due within one year Progressively higher ratios nify increasing ability to service short-term obligations Bear in mind thatliquidity in a specific business is an element of asset composition Thus,the ‘‘acid test’’ ratio that follows is perhaps a better indicator of liquidityoverall In this particular business, we must note that $92,155 of currentassets are sales promotion devices that are unlikely to be turned back intocash per se.

sig-Total Current Assets

Total Current Liabilities

Industry Median

Note: Unreconstructed balance sheet used.

The quick, or acid test, ratio is a refinement of the current ratio andmore thoroughly measures liquid assets of cash and accounts receivable

in the sense of ability to pay off current obligations Higher ratios indicategreater liquidity as a general rule

Cash and Equivalents Ⳮ Receivables

Total Current Liabilities

Industry Median

(Income Statement) Sales

Sales/Receivable Ratio ⳱ or

Receivables (Balance Sheet)

1990 1991 1992

Industry Median

This is an important ratio and measures the number of times that ceivables turn over during the year Our target company seems to turnthese over in tune with the industry median

This highlights the average time in terms of days that receivables areoutstanding Generally, the longer that receivables are outstanding, thegreater the chance that they may not be collectible Slow-turnover ac-counts merit individual examination for conditions of cause In our caseexample, three years show inconsistency in collections although they dofall within the industry median range

Note: Cost of sales and cost of goods sold are interchangeable terms.

Generally, the higher their turnover rate, the shorter the time betweenpurchase and payment Lower turnover suggests that the company mayfrequently pay bills from daily in-store cash receipts due to slower receiv-able collections This practice can be somewhat misguided in light of in-vestment principles whereby one normally attempts to match collectionsrelatively close to payments so that more business income can be directedinto the pockets of owners Some businesses may, however, have littlechoice

Sales

Sales/Working Capital Ratio ⳱ or

Working Capital

1990 1991 1992

Industry Median

Note: Current assets less current liabilities equals working capital.

A low ratio may indicate an inefficient use of working capital, whereas

a very high ratio often signals a vulnerable position for creditors Ourtarget company has been below the median and may increasingly be grow-ing inefficient in the use of its working capital

To analyze how well inventory is being managed, the cost of sales toinventory ratio can identify important potential shortsightedness

A higher inventory turnover can signify a more liquid position and/orbetter skills at marketing, whereas a lower turnover of inventory may in-dicate shortages of merchandise for sale, overstocking, or obsolescence ininventory Our case example falls into the lower quartile as regards inven-tory management This should signal the need for a particular examination

of inventory as to quality and size

Conclusions

Financial analysis does not conclude with ratio study, but for our purpose

it will suffice Sales have been flat, the owner losing interest, and perhapshis territory ‘‘maxed’’ out If his assessment for growth is accurate, thevalue of his business is to be found in the history up to 1992 Growth byway of new product development or new locations can be costly growth.Certainly the values in these ideas belong to the person who pays for andexecutes them, and maintaining present levels in sales may take more thanjust labors of love This case exhibits conditions where the use of ‘‘dis-

counted’’ processes may be least likely to produce satisfactory results.

The Valuation Exercise

Book Value Method

Total Assets at Year-End 1992 $968,340

Book Value at Year-End 1992 $575,015

Adjusted Book Value Method

Assets

Balance Sheet Cost

Fair Market Value

Adjusted Book Value at 1992 $ 575,015 $ 765,460

1 While sample material may have little resale value, promotional devices are necessary to generate sales Subsequently, when the business is sold as a ‘‘going concern,’’ these items can be included

at book value I caution, however; sales promotion items can experience very short life spans, particularly in a home decorating business where styles change rapidly.

2 Stated at appraised and, thus, fair market value.

Hybrid Method

(This is a form of the capitalization method.)

1⳱ High amount of dollars in assets and low-risk business venture

2⳱ Medium amount of dollars in assets and medium-risk business

venture

3⳱ Low amount of dollars in assets and high-risk business venture

1 2 3 Yield on Risk-Free Investments Such as

Government Bonds a (Often 6%–9%) 8.0% 8.0% 8.0% Risk Premium on Nonmanagerial Investments a

(corporate bonds, utility stocks) 4.5% 4.5% 4.5% Risk Premium on Personal Management a 7.5% 14.5% 22.5%

busi-Book Value at Year-End 1992 $575,015

Add: Appreciation in Assets 190,445

Excess Earnings Method

(This method considers cash flow and values in hard assets, estimates tangible values, and superimposes tax considerations and financing struc-tures to prove the most-likely equation.)

Net Cash Stream to Be Valued $ 171,935

Cost of Money

Market Value of Tangible Assets, Minus Liabilities 1

(see reconstructed balance sheet) $1,051,465

Excess of Cost of Earnings

Return Net Cash Stream to Be Valued $ 171,935

Less: Annual Cost of Money ⳮ 105,147

Excess of Cost of Earnings $ 66,788

Intangible Business Value

Times: Intangible Net Multiplier Assigned ⳯2.5*

Intangible Business Value $ 166,970

Add: Tangible Asset Value 1,051,465

TOTAL BUSINESS VALUE (Prior to Proof) $1,218,435

(Say $1,220,000) Financing Rationale

1 Minus liabilities whenever liabilities are sold with business.

*Refer to Figure 9.1 ‘‘Guide to Selecting Net Multipliers,’’ in Chapter 9.

At this point, we must gauge the amount in prospective bank financing.It’s important to use a good deal of logic at this stage of valuation or youwill waste a lot of time coming up with reliable estimates One can set upthe financing scenario any way appropriate to the local conditions, but myguess is that the following would be pretty close

$75,750 in 1992 70% of $75,750 equals $53,025 and annual payments of principal and interest

on $460,000 of debt equals $53,269 Neat little ‘‘cushion,’’ wouldn’t you say?

I must interrupt the process flow for a moment to remind readers thatreal estate sold with a ‘‘going concern’’ should be treated just as all other

assets for the purpose of business valuation Unless, of course, intangible

business value in the foregoing calculation is ‘‘0’’ or a negative number

In that case, there is no business value to report in excess of the values in

hard assets, including real estate Such being exhibited translates into

assets-only for sale, and, subsequently, appraisal of assets versus businessvaluation would be the assignment undertaken However, one should notneglect a possibility that real estate could be leased rather than sold Inour example, real estate enjoys strong cash flows and could remain anexcellent investment for the previous business owner In this event, busi-ness value would be examined without the real estate asset, expenses in-creased to include ‘‘rent’’ paid, and the rental income removed fromreconstructed cash flows So many years using the ‘‘excess’’ method havetaught me the ‘‘gut-feel’’ as to which way to initially proceed When in

doubt, I start as I have here, because a facility is necessary to conduct

business, and one way or the other, there will be a cost associated withhousing The formula walks me into examining the correct pew I mustultimately consider In spite of what I’ve just said, real estate and otherhard assets will always have ‘‘stand-alone values.’’ These must be known

to the best of your ability, regardless of the strengths or weaknesses ofbusiness cash flow Business-value estimating that portends to depress fairmarket values of real estate and other hard assets is irresponsible reporting

Bank (10% ⳯ 20 years)

Annual Principal/Interest Payment 68,324

Testing Estimated Business Value

Return: Net Cash Stream to Be Valued $171,935

Less: Annual Bank Debt Service (P&I) ⳮ 68,324

Less: Est Dep & Amortization (Let’s Assume) ⳮ 33,930

Less: Estimated Income Taxes (Let’s Assume) ⳮ 1,600

Net Operating Income (NOI) $ 79,781

*Debt service includes an average $11,700 annual principal payment that is traditionally recorded

on the balance sheet as a reduction in debt owed This feature recognizes that the ‘‘owned equity’’

in the business increases by this average amount each year.

Return on Equity:

Pretax Equity Income $115,311

Down Payment $300,000

Return on Total Investment:

Net Operating Income $ 79,781

Total Investment $1,120,000

Although return on total investment is abysmally low in relationship toconventionally expected investment returns, the return on equity is at-tractively high and cash flow is strong.

a deal If we leave the price at $1,220,000, either the buyer has to make

up the difference outside this business, or the seller must become flexibletoward providing $330,000 of seller financing, or find another buyer withmore cash, or the estimated price must be ‘‘squeezed’’ to fit the conditions

of the projected buyer Stated at the outset, our seller agreed to providesome financing, as long as he could realize at least $250,000 prior topersonal taxes The $890,000 forecast through down payment and insti-tutional financing more than meets the target, thus we can proceed toinsert seller debt into the equation

Annual Principal/Interest Payment 48,046

Total Annual Principal/Interest Payment $ 116,370

Testing Estimated Business Value

Return: Net Cash Stream to Be Valued $ 171,935

Less: Annual Bank Debt Service (P&I) ⳮ 116,370

Less: Est Dep & Amortization (Let’s Assume) ⳮ 33,930

Less: Estimated Income Taxes (Let’s Assume) –0–*

Net Operating Income (NOI) $ 47,969

*Debt service includes an average $26,334 annual principal payment that is traditionally recorded

on the balance sheet as a reduction in debt owned This feature recognizes that the ‘‘owned equity’’ in the business increases by this average amount each year Tax obligations are reduced since increased interest expense is deductible from business cash flow.

Return on Equity:

Pretax Equity Income $ 81,899

Down Payment $300,000

Return on Total Investment:

Net Operating Income $ 47,969

Total Investment $1,220,000

Note that returns change quite a bit under our new scenario, but thereturn on equity is still high in relationship to alternative investments forthe $300,000 cash being used as down payment

Buyer’s Potential Cash Benefit

Pretax Cash Flow (contingency not considered) 55,565

Income Sheltered by Depreciation 33,930

Discretionary and Nondiscretionary Cash $160,829

*Assumes that buyer would increase salary to avoid double taxation by paying taxes at the business level.

As a matter of practicality, I know that the owner of this business drew take-home pay slightly over $160,000 in pretax 1992 dollars Theactual earnings of a present owner has always been somewhat of a bench-mark criterion that I shoot for in terms of evaluating a prospective buyer’spotential earnings Some people remark that this is giving away the

with-‘‘kitchen sink,’’ but I don’t think so, particularly when you consider that

owners can stay in their businesses and continue to earn if they wish to

do so I have another philosophy to share: Buyers are not obligated tofeather the nest of sellers ever! There’s a happy median for both, and

that’s usually the point at which sellers and buyers are equally stretched

by the process of actual sale To my way of thinking, that is where truebusiness value lies Prospective buyers should not, in the process of pur-chase, be able to immediately earn more than sellers have earned, but atthe same time, sellers cannot expect to earn from their buyers what theycould not earn from their business while they ran it The debt leverage ofcash streams can be tight as a drum in the purchase of fast-growing com-panies, but in cases like this retail operation, where sales, earnings, and

growth are stagnant, the prospective buyer deserves wiggle room to expand

the business in years to come That means that more ‘‘jingle’’ must bedumped into the buyer’s equation or the business simply won’t sell If theestimated value does not forecast a likely sale, then the estimate is wrong period!

Seller’s Potential Cash Benefit in Sale

*From which must be deducted capital gains and other taxes Structured appropriately, the deal qualifies as an ‘‘installment’’ sale with the proceeds in seller financing put off regarding taxes until later periods.

Projected Cash to Seller by End of 10th Year

Add: Projected 10-Year Principal and Interest Payments to Seller 480,457

This owner paid $600,000 for his business seven years ago That’s128.4% return on his original purchase, or an average dollar return of

$110,065 per each of the seven years between 1986 and now This doesnot include what he earned in the way of salary for operating his business

$290,000 over his original purchase ($890,000 in cash minus $600,000)might be likely realized on a date of sale Calculated any way one wishes,return to this owner is just and wouldn’t be likely to be repeated in thestock market or in a job with corporate America Want to know the end

of the story? I’m happy—this was my business I was the seller! I sold

the business separate of real estate, ultimately sold the real estate later to

an investment group, sold the wholesale carpet division separately, and Igrew richer in the process The years were 1969, 1970, and 1971—not

1990, 1991, and 1992 as herein stated to keep a secret up to this point.

I returned to college during 1970 and spent less than two hours per ness day in my operation Thus labor costs fit the scenario for me How-ever, my time away did have an impact on business

busi-Today, I value other businesses as I did through the purchase and sale

of five small companies—from the trenches, not from academia! Today Iown two enterprises alone, and two others with partners I didn’t havetwo sticks to make fire when I started my small-business rampage nearly

30 years ago Business valuation is estimating what real players will do,and real players add eons to the yardsticks of conventionally acceptedmeasurement Ignore how buyers think and act, and you’re guaranteed

to miss your target estimation Comparable business sales are virtuallyuseless because there are no comparable business operators Individualsare unique and not very predictable less so for buyers who read books

Forget the Scientist, This Is What Counts Method

Cash Flow (commonly used last completed year,

assuming that conditions of the business

At 7 times earnings value ⳱ $ 738,955

At 9 times earnings value ⳱ $ 950,085

Business Is Fairly Priced If:

1. Asking price is not greater than 150% of net worth (except wherereconstructed profits are 40% of asking price)

a. Net worth $1,051,465 times 150% equals $1,577,198

b. Reconstructed profits $221,935 divided by asking price

$1,220,000 equals 18.2%

2. At least 10% sales growth per year being realized

a. No growth

3. Down payment is approximately the amount of one year’s structed profits.

I split my sale of business and real property; because, as with many sellers,

I too wanted my price That’s what is so good about small business—owners and purchasers can be flexible as to final deals

we were to average the low and high at 1.12, $640,127 would be forecast

as value not including real estate When using rule-of-thumb ing, these ratios rarely, if ever, take the value of real estate into consider-ation Real estate cannot be arbitrarily added to the rule-of-thumb value,and purchase of facilities must meet the test of cash flow

Hybrid (capitalization) Method 1,127,344

Forget the Scientist Method $738,955 to 950,085

Rule-of-Thumb Estimate $887,740 to 1,331,610

As mentioned elsewhere, I traditionally calculate the book and adjustedbook value scenarios, although I know that good operations will rarelychange hands at these prices Data from these, however, are an importantconsideration to the hybrid and excess earnings formulas; and becausesome businesses have not produced cash flows strong enough to supportvalues beyond these hard-asset values Thus overall business values maynot be greater than the values they hold in these hard assets

We guessed from initial review of the balance and income statementsthat this retail operation had an added overall intangible value that wasgreater than the value in its assets What we didn’t know at that time washow much more could be justified

For added flavor, the new business owner leased the facilities for

$14,400 per year This plus the $75,750 rental income came to $90,150triple net real estate income The business was sold for $550,000 and realestate later at $700,000 Together, these sales derived $1,250,000 Thewholesale portion was another source of profit Needless to say, I’mpleased to report that seller financing kept my kids in shoes for quite awhile

The Japanese have a philosophy about life that we Americans might well be advised to adopt: kaizen (continuous improvement) Business valuation processors cannot possibly know it all, but they can always benefit through continuous improvement I, for one, have no other choice; I do it to survive.

W.M.Y.

16

Retail Hardware Stores

Smaller retail hardware stores can be distinguished from other retail tions by the vast complexity of diversified lines of merchandise For ex-ample, most serve virtually every trade contractor, such as plumbers,electricians, millers, roofers, painters, and builders, as well as do-it-your-selfers Lines can include lawn and garden suppliers, power generators,garden tractors, tools, housewares, unpainted furniture, car supplies,Christmas items, sportswear, artist supplies, toys, interior decorating ma-terials, greeting cards, glassware, farm equipment, and so on Individual-store inventory tends to model the general needs within the communitywherever the store is located

opera-Sales in hardware stores are less likely to be affected by seasonal upsand downs, since much of their merchandise can be ‘‘shifted’’ to meetseasonal characteristics Fall and spring may provide a little more volume,and as with many other retail stores, the first two months of each newcalendar year can be somewhat slack from overexpenditures leading up toChristmas

Independent retail stores are faced with tough competition on manyfronts these days Chain and discount stores, lumber dealers with hardware(and few don’t have it), and specialty dealers such as paint, electrical, andplumbing wholesalers affront daily the small independent from all angles.Because of quantity buying discounts enjoyed by the ‘‘bigs,’’ independ-ents have been forced to model their general inventories after lower-pricedmerchandise and/or be very selective over what, if any, high-quality prod-ucts might be carried However, many independents benefit and survive

by joint buying cooperatives such as Ace, True Value, Coast-to-Coast, andothers The key to successful operation and survival can weigh heavily ineffective management of contribution ratios per department or product

line Computerization plays a vital role, or should do so, in daily ment.

manage-Inventory control is essential if one is to be successful in the retailhardware game Misguided purchasing decisions, particularly seasonalmerchandise, can create costly storage and holding problems Daily cashand charge sales, stock replenishment, pricing, and so on can quickly getout of control if not rigorously watched

Brief Case History

This retail hardware business serves customers from three leased facilitieslocated approximately 30 miles apart The two larger units now suffermajor competition caused by the opening of a Wal-Mart midyear 2000,which is situated equidistant from these stores The units are absentee-owned by a wealthy medical professional who bought them originally as

an investment

I am including this case for several reasons: (a) to show you shouldnever be impressed by the size of sales alone; (b) to point out pitfalls ofabsentee ownership, especially in this type of business; and (c) to showhow value is affected by the distressed nature of a business

When assignments involve multiple sites, financial analysis should ways include the study of each store individually, as well as profit contri-butions for each product line by individual store However, for thepurpose of brevity in this chapter, we will use the following consolidatedstatements

al-Retail Hardware Stores (Three Locations Consolidated) Balance Sheets (Not Reconstructed)