1 2 3 Yield on Risk-Free Investments Such asRisk Premium on Nonmanagerial Investments a Risk Premium on Personal Management a 7.5% 14.5% 22.5% busi-Weighted Cash Streams Prior to complet
Trang 1(Income Statement) Sales
Receivables (Balance Sheet)
Industry Median
This is an important ratio and measures the number of times that ceivables turn over during the year It symbolically represents my preced-ing comments wherein garden centers tend largely to generate cash sales.Although our target company seems to have slipped a bit in 2001, thiscould be no more than a quirk, since other years have been relativelystable However, it points to questioning why receivables more than dou-bled in 2001
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, four years show regularity in collections, and a sharp peak occurs
in 2001 Much of the problem rests in two larger ‘‘jobs’’ where there wasjoint agreement for 90-day terms
Generally, the higher the turnover rate, the shorter the time betweenpurchase and payment Lower turnover, which our target company ex-periences, indicates that it may frequently pay bills from daily in-store cashreceipts due to slower receivable collections This practice may be some-what misguided in light of investment principles, whereby one normallyattempts to match collections relatively close to payments so that more
Trang 2business income can be directed into the pockets of owners Some nesses may, however, have little choice Our company owner admits tobeing lax at pursuing collections but claims never to have suffered baddebt as a result.
Note: Current assets minus 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
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.Our case example, while improving, falls into the lower quadrant andsuggests inventory may be quite heavily overstocked or contain largeamounts of distressed or unsalable merchandise
Conclusions
This case presents a fairly stable operation with one possible exceptioncaused by what appears to be excessive inventory Close examination ofinventory revealed two important facts Six years ago, two acres wereplanted with seedling ornamental shrubs of their highest turnover cate-gory These are harvestable in two years, and a rotational grow/sell planhas been developed The present owner believes that this move curtailsincreasing problems with supply and will increase gross profits if the prac-tice is continued Inventory, therefore, has been accepted at current levelsfor the purpose of business valuation
Trang 3The Valuation Exercise
Book Value Method
Adjusted Book Value Method
Assets
Balance Sheet Cost
Fair Market Value
*See reconstructed balance sheet.
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
Trang 41 2 3 Yield on Risk-Free Investments Such as
Risk Premium on Nonmanagerial Investments a
Risk Premium on Personal Management a 7.5% 14.5% 22.5%
busi-Weighted Cash Streams
Prior to completing this and the excess earnings method, we must oncile how we are going to treat earnings so that we have a ‘‘single’’stream of cash to use for reconstructed net income I prefer the followingtechnique:
rec-(a)
Assigned Weight
Weighted Product
Trang 5sales jumping up by 19.1% in 2001 The free cash stream grew by 41.1%that year Mathematicians may not agree with my following simple logic,but it works for me every time If nothing more, it gives tangible recog-nition for unusually good performance, all of which is verified in previousyears However, valuators should always assure themselves that there isreasonable likelihood for future repeat performances and that an excep-tional year is not a quirk occurrence.
What we now need to decide is the ‘‘power’’ of the sales/income factor
in the weighted cash stream Again, not from the books of cians, but working well: Sales grew by 19.1%, and income by 41.1%, thus,divide 41.1% by 19.1% and we get 2.2%—rounded, a factor of (2) Wecan now complete our weighting process
mathemati-(a)
Assigned Weight
Weighted Product
Trang 6Excess 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.)
Cost of Money
Market Value of Tangible Assets
Excess of Cost of Earnings
Return Net Cash Stream to Be Valued $ 93,960
Intangible Business Value
Times: Intangible Net Multiplier Assigned ⳯5.0*
TOTAL BUSINESS VALUE (Prior to Proof) $733,995
(Say $735,000) Financing Rationale
Less: Down Payment (approximately 25%) ⳮ 185,000
*See Figure 9.1 in Chapter 9 for net muliplier.
Once again we must draw assumptions (best to specifically check outwith local bankers) prior to completing our assessments The followingrepresents preliminary quotes from a commercial bank in the locale of ourtarget company
Land & Building ($320,000) at 70% of Appraised Value $224,000 Equipment ($23,770) at 70% of Appraised Value $ 16,639
(Say $325,000)
*Inventory contains approximately $40,000 of shrubs and plants in the ‘‘growing’’ stage that are possibly not harvestable for about two years This business is located in a northern zone where seasonally unsold plants and shrubs must be planted or maintained through winter months Subsequently, winter kill could be high as viewed by the bank.
Trang 7Bank (10% ⳯ 15 years)
Testing Estimated Business Value
Less: Est Dep & Amortization (Let’s Assume) ⳮ 18,313
*Debt service includes an average $6,100 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 (ROE):
Pretax Equity Income $ 62,425
Down Payment $185,000
Return on Total Investment (ROI):
Net Operating Income $ 33,974
Total Investment $735,000
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 As mentioned so often along theway, I do not believe that small-company buyers pay all that much heed
to ROI it’s King Cash that leads the way
Buyer’s Potential Cash Flow Benefit
On the one hand, we have estimated business value; on the other hand,
we may not have hit our target estimation A $185,000 cash down
Trang 8pay-ment plus $325,000 bank financing, or $510,000, leaves us with a
$225,000 shortfall yet to be financed If we leave the price at $735,000,either the buyer has to make up the difference outside this business or theseller must become flexible toward providing $225,000 of seller financing,
or find another buyer with more cash, or the estimated price must be
‘‘squeezed’’ to fit the conditions of this buyer How then might we resolvethe discrepancy?
1. We know that we are $225,000 short of financing
2. We know that we have an income stream of $97,288 ($103,388minus noncash equity buildup $6,100) A decent stream in light ofcash outlay at purchase
3. We know that most sellers are anxious to receive cash as quickly aspossible
4. Assuming that a salary of $45,000 is typical to equivalent work ing done by other managers in this field, then we can also assumethat we have wiggle room to retrofit additional financing into theequation (but we must still leave room for down payment invest-ment returns of some sort)
be-In attempting to solve for this question, we return to the point in theequation for Financing Rationale
Total Annual Principal/Interest Payment $ 92,382
Testing Estimated Business Value
Return: Net Cash Stream to Be Valued $ 93,960
Less: Annual Bank Debt Service (P&I) ⳮ 92,382
Less: Est Dep & Amortization (Let’s Assume) ⳮ 18,313
Less: Estimated Income Taxes (Let’s Assume) –0–
Net Operating Income/Loss (NOI) $ –6,704
Trang 9A bit ‘‘tight’’ you say? You’re right it is too tight to sell to a buyer
of this garden center Bear in mind that we did just this in a previousexample, but that case had much higher cash flow and personal earnings
to a potential buyer I use a rule-of-thumb earnings (as full cash proceeds)
to a buyer predicting a return of down payment in about three years Thus,
in this example, $185,000 divided by three equals approximately $62,000between estimated salary and business returns This will not always be thecase, of course, but it is a reasonable expectation So, let’s try the ‘‘fi-nancing’’ and ‘‘testing’’ portions again
Total Annual Principal/Interest Payment $ 70,394
Testing Estimated Business Value
Return: Net Cash Stream to Be Valued $ 93,960
Less: Annual Bank Debt Service (P&I) ⳮ 70,394
Less: Est Dep & Amortization (Let’s Assume) ⳮ 18,313
Less: Estimated Income Taxes (Let’s Assume) ⳮ 1,875*
*Debt service includes an average $21,063 annual principal payment (increases from $10,031 with addition of seller financing) 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 Tax obligations are reduced since interest expense is deductible from business cash flow.
Return on Equity:
Pretax Equity Income $ 44,630
Down Payment $185,000
Return on Total Investment:
Net Operating Income $ 24,441
Total Investment $735,000
Trang 10Note that return on equity drops considerably under our new scenariobut is still in the range of good return on the $185,000 down payment.Let’s now look at how the buyer might view this posture.
Buyer’s Potential Cash Benefit
Although the business’s cash flow would be quite leveraged ($70,394
P & I) during the first 10 years, the buyer would have earned slightly lessthan the seller was earning at the time of his exit Some folks disagree withthis belief, but in my opinion, another ‘‘test’’ of estimating value is a
finished equation that predicts cash outflows roughly equal to what a seller
had been capable of earning in the year of transition
Seller’s Potential Cash Benefit
*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 Tenth Year
Add: Projected Annual Principal/Interest Payments 327,580
If our garden center owner wishes to obtain maximum yield on price,then the seller financing must be considered Chapter 10, ‘‘Practicingwith an Excess Earnings Method,’’ demonstrates how one can experi-ment with alternative modules that provide wiggle room for seller ne-gotiations with buyers Decreasing bank and seller debt in our exampleleaves room for the possibility of refinancing both notes at about yearseven-and-one-half But a five-year balloon payment on seller debtwould be impractical, since restructure in five years would be unlikely
Trang 11to cover all debt An all-cash at closing scenario would forecast pricecompression near to the value of hard assets.
Forget the Scientist, This Is What Counts Method
Cash Flow (commonly used last completed
year, assuming that conditions of the
Return on Equity: $80,938 minus salary $45,000 equals $35,938, divided by $185,000 equals
19.4%.
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 $528,390 times 150% equals $792,585
b. Reconstructed profits $151,332 divided by asking price
$735,000 equals 20.6%
2. At least 10% sales growth per year being realized
a. Three growth periods in the four years equal 30% or about 10%per year average
3. Down payment is approximately the amount of one year’s structed profits
recon-a. $185,000 minus $151,332 or $33,668 (22.2%) more
4. Terms of payment of balance of purchase price (including interest)should not exceed 40% of annual reconstructed profit
a. Debt service $70,394 divided by $151,332 equals 46.5%
What does all this mean for estimated value? It means that the price ofthe deal in the eyes of buyers, if they have read from a multitude of pub-lications whence this information was gleaned, could be viewed as just
about right Subsequently, we might estimate most-likely value to be
Trang 12$735,000 Considering that garden centers or nurseries sit on the higherend of the desirability scale for all buyers in general, we might also rec-ommend that a seller offer the business in the market at $750,000 to start.
Results
As you might note, this is the first time in our examples that the forgetthe scientist and excess earnings methods show the same results Assumingthat forget the scientist models general buyer practice, then this fact mightsuggest an early sale of this garden center To some it might also suggestthat we have underpriced the business but that’s not really true As ageneral rule, any time that down payment requirements exceed $100,000there is a great tendency in buyers to seek cash flows of substance and,usually, above average personal earnings capacities As we approach the
$200,000 down payment mark, we begin to tap buyers of a more ticated category Garden centers and nurseries, while they do enjoy goodbuyer appeal, largely fit into the category of ‘‘lifestyle’’ enterprises Thus,growth of revenues can be quite slow under even the best of circum-stances Buyers of these and similar businesses are inclined to negotiatemuch harder to achieve ‘‘day-one’’ cash flows because they recognize thatthe growth of personal earnings is likely to be slow in coming
sophis-For many reasons, the issue of forecasting practical levels for growthmust be fully understood by value processors Sellers quite normally getcaught up in ‘‘dream’’ rates of growth (and they shouldn’t unless previousactions show that they have done it themselves), and buyers quite normallyare doubt-ridden about seller’s predictions; therefore, value estimatingthat tips too far one way or the other tends to unleash ‘‘no-interest/no-sale’’ results Pricing for lifestyle businesses will tend to fall into the
‘‘where is, as is’’ model
Trang 13at the time of negotiations I have a bone to pick with this reluctance orrefusal on the part of sellers Yes, what one originally paid for somethingbeing sold today has no bearing on its present value However, historytells the best story about present values Outstanding performances re-corded from the past can become a major selling point to the benefit ofsellers Inabilities to complete a range of ratio studies in support of hard-asset values serve only to weaken the sellers’ overall case At some point
in the negotiation process, it is likely they are going to be required todisclose this information to buyers or their accountants so why not
up front? Withholding, in my opinion, smacks of impropriety and leaves
me suspicious as heck What do you think it does for buyers?
Brief Case History
The owner purchased this business approximately 25 years ago Sales wereless than $100,000 and the store occupied about one-third the present-day selling space of 3,700 square feet The U.S Postal Service leases anattached storefront with 10 years remaining on the lease The buildingwas completely renovated in 2000 and has been appraised at $270,000.Fixtures and equipment have been appraised at $54,000, and inventorytaken three weeks prior to valuation was set at $58,500 Wages include
$18,500 for a shift supervisor that might be filled by a purchaser’s grown
Trang 14son or daughter if desired The position is necessary due to 18-hour erating days, and therefore, not removed from expenses.
op-The store is located in a mixed residential/light industrial area Fivesmall manufacturing plants are within reasonable walking distance andafford the owner a 60% windfall gross profit on approximately $158,000
of sales from the store’s no-table-service luncheonette The closest perstore’’ grocer lies 22 miles away, and the semirural setting makes itunlikely that a larger competitor will locate closer to his facility Retirementand sale of the store are the owner’s stated purpose for valuation
‘‘su-What’s Being Sold in the Way of Hard Assets
Assets
Fair Market Value
Estimate 2001
Trang 151998 1999 2000
Estimate 2001
peaked supported entirely by the owner’s own estimate for the balance
This ratio measures the percentage of sales dollars left after cost ofgoods sold are deducted Slightly higher than the industry median, thissmall grocery store shows the results of opportunity management