In today’s volatile marketplace, your company is either growing or going backwards. There is no such thing as standing still in these turbulent times.
As a Meridian client, your company is likely on the grow. And, if your company is typical of the industry, some of that growth will come from acquisitions of other sites or companies. Therefore, one of the most frequent questions we are asked at Meridian is how to value a potential acquisition.
There is no one simple answer when it comes to valuation, but there are a few tried-and-true strategies to determine the value of an established business operation. If you are in agreement that the crux of any business purchase is future cash flows, then it makes perfect sense to use a cash flow method for valuation.
By using a combination of market value of hard assets, the expected return on those assets and the “goodwill” value of cash flows, we can determine the worth of a business and then assess that purchase against other investment opportunities. Let’s use an example to illustrate this valuation method.
Your company is considering the purchase of ABC Company. ABC’s owner is at retirement age. He tried to involve his children in the business but without success: they moved away and have careers independent of the family oil business. ABC has $2,500,000 in book-value hard assets.
ABC’s owner called you because you carry the same major brand and he knows you are expanding geographically. ABC has a fairly loyal customer base but they’ve lost a few customers lately due to a low-price competitor. ABC is a small, clean bulk plant operation.
ABC’s owner wants a “fair” price for his business. Although business has dropped off a little in the past few years, he is counting on the sale of this business to fund his retirement. He asks you to make an offer.
Step 1 – Value the Tangible Assets
Request that ABC’s owner provide you with a complete list of all real estate, vehicles, and equipment owned by the company. Through either third-party appraisals or your own evaluation, determine a market value (which may be significantly different from the $2,000,000 book value on ABC’s balance sheet) for all the assets. For instance, if ABC were to sell its trucks, what would they go for? Adding up the value for each asset, determine a total.
Step 2 – Calculate Past Cash Flow
Take ABC’s net profit (see table), then add back depreciation and any owner’s compensation in excess of what you will need to pay an onsite manager to run the operations. This is the company’s historical cash flow. You decide that a manager for ABC’s site will cost $65,000 annually. Therefore, the excess owner salary at ABC was $60,000 in year 1, $50,000 in year 2 and only $35,000 in year 3. Adding profit and depreciation, we get historical cash flow of $275,000 for year 1, $211,000 in year 2 and $146,000 in year 3.
With a stable company, we would take an average of the past cash flows to determine future cash flows. In the case of ABC, the cash flow is steadily decreasing each year — by $64M in year 2 and another $65M in year 3!
If we assume this cash flow trend continues, ABC’s cash flows will only remain positive for another two years. The company could be losing money by year 6! But ABC’s owner convinces you that the company will not lose any more margin and that they have stabilized at $146,000.
| ABC OIL COMPANY PROFIT STATEMENT | |||
| Year 1 |
Year 2 |
Year 3 |
|
| Sales | $10,953,000 | $9,874,000 | $8,536,000 |
| Gross Profit | $1,533,000 | $1,284,000 | $1,024,000 |
| Owner Salary | $125,000 | $115,000 | $100,000 |
| Depreciation | $111,000 | $98,000 | $75,000 |
| Other Expenses | $1,193,00 | $1,008,000 | $813,000 |
| Profit Before Tax | $104,000 | $63,000 | $36,000 |
Step 3 – Determine Earnings Attributable to Book Value Assets.
Since ABC is 90% wholesale and 10% retail, we calculate an expected return of 5.2%. Using the $2,000,000 book value assets, we expect a return of $104,000 ($2MM times 5.2%).
Step 4 – Determine Present Value of Predicted Cash Flows Attributable to Goodwill.
From Step 3, we determined that $104,000 of ABC’s $146,000 in annual cash flow is expected return on assets. This means that $42,000 per year is attributable to ABC’s customer base or goodwill.
How long you can count on this income? For an arms-length transaction, most purchasers use five years. Using a present value annuity table, we would look up the discount factor for a five-year annuity using an interest rate equal to our own company’s return on assets. For purposes of this example we’ll use 6% as our own return on assets, which equates to a factor of 4.212 for five years. Multiplying $42,000 by our factor of 4.212, we derive goodwill value of $176,904. We would then add this amount to the market value of ABC’s assets (Step 1) for our offer price.
Before making an offer, though, analyze the total investment and annual return from ABC versus other opportunities you may have (build your own cardlock, c-store, etc.). If your dollars can produce better return elsewhere, don’t spend the money on ABC.
Note: There are myriad considerations not factored into this short example such as economies of scale. Buyers, however, should never pay a premium to a seller for potential earnings their size or management expertise can bring to an acquisition.
