Archive for September, 2007

You can measure the value of a manufacturing firm using a number of well-known methods under the market, income and asset approaches to business valuation. However, to get accurate business valuation results you need to focus on two key points.

1. Identify and include all income-producing assets in your manufacturing company valuation. 

More so than most other business types, manufacturing firms use a large number of assets. Property, plan and equipment typically represent a large portion of the manufacturing company’s investment.

Off-balance sheet assets such as internally developed intellectual property are very common. Product and process technologies can be licensed to generate additional income streams which increase business value.

At the same time, a manufacturing firm may have some assets on the books that do not currently contribute to income generation. Other assets, such as plant capacity, may not be fully utilized to produce income. If fully exploited, the value of these assets can be substantial.

2. Base your business valuation on a realistic cash flow forecast and business risk assessment. 

Accurate estimation of the income-producing capacity for a manufacturing business may be challenging. Yet it is essential in defining what the business is worth.

Manufacturing firms invest heavily in developing new products and processes. And all products have a finite life cycle. Without constant innovation, technology obsolescence sets in quickly, reducing the income derived from product sales.

The levels of capital investment needed, and the accuracy of sales projection make a major difference to the manufacturing firm’s income prospects. Market acceptance of new products and competitive response also affect how successful a product launch is.

In terms of valuing a manufacturing business, this requires that you capture these elements in your cash flow forecast and business risk assessment.

Recasting historic financial statements for manufacturing business valuation

To determine the value of a privately owned manufacturing company, you need to construct an accurate picture of the business assets and income. You do this through the process of adjusting or normalizing the historic balance sheet and income statements.

Balance sheet reconstruction for valuing a manufacturing company

Here are a few guidelines for recasting your balance sheet:

Assets:

  • Remove cash levels in excess of operating requirements.
  • Remove uncollectible accounts receivable. Check the aging report.
  • Adjust all inventory to market value, focusing on the work-in-process and finished goods levels. Remove obsolescent inventory.
  • Adjust all long-term assets to their fair market value. In a business sale situation, include only those hard assets that will be included in the transaction.
  • Determine the current value of any prepaid expenses.
  • Remove shareholder loans.
  • Value the business owned real estate separately.

Liabilities:

  • Ensure that all currently owed amounts are included in the accounts payable.
  • Verify all accrued expenses such as payroll and taxes due.
  • Determine the customer deposit levels and only include those that can be transferred to the business buyer.
  • Remove loans from business owners.
  • Remove any real estate loans.
  • Identify any contingent liabilities that may not appear on the historic balance sheet. Examples are possible legal expenses, and regulatory compliance costs.

Recasting the company’s income statements and preparing cash flow forecasts

Your focus when recasting the historic income statements and preparing a future cash flow forecast is to show an accurate picture of the business earning potential. The key points to consider are these:

Sales:

  • Realistic revenue projections from sales of new products and services.
  • Can historic levels be sustained in the future? Consider the product life cycle and competition offerings.
  • Review the current sales order backlog against historic numbers.
  • Check the accrual of customer deposits against actual product delivery.
  • If some customers account for a larger percentage of sales, assess the likelihood of this continuing. Adjust your sales projections if sales to some large customers can be lost.

Cost of Goods Sold:

  • Supplier stability and anticipated cost trends.
  • Watch out for changes in inventory costing and direct labor accounting.
  • Assess the risk of reliance on “single-source” suppliers.
  • What prices and terms will the business buyer receive?

Expenses:

  • Check and adjust for owner-discretionary spending such as auto, advertising, phone, travel and entertainment expenses.
  • Make sure that there is adequate business insurance and account for any premium increases if needed.
  • Remove any personal charges from the professional expenses such as legal and accounting fees.
  • Identify all compensation components for the principal owner-operator. This is an important part of your seller’s discretionary cash flow estimation.
  • Adjust the salaries of all other working owners to market rates. This is also known as the “manager replacement” adjustment.
  • Check the rent expense. If the business sells and a new lease needs to be signed, your cash flow forecast should reflect this change.

Choosing the business valuation methods

With your financial statement adjustments and forecasts ready, you can choose your business valuation methods. Some of these methods are especially useful when valuing a manufacturing business:

Market-based valuation of manufacturing businesses

Under the well-known Comparative Transaction Method, you basically compare your business with similar manufacturing companies that have sold in the recent past.

There is a strong market for private firms in many segments of the manufacturing industry. Valuation multiples derived from such business sales can help you determine the fair market value of your business in a very compelling way.

For small manufacturing firms, the valuation multiples of choice are based on the business revenues and earnings. In other words, you can estimate your business value by applying such multiples to your own business revenue or earnings.

Income-based business valuation: Discounted Cash Flow and Multiple of Discretionary Earnings methods

The Discounted Cash Flow method is a common way to value manufacturing companies. You can obtain very accurate business valuation results based on your business cash flow forecast and the discount rate, which captures the business risks. You can determine the discount rate using standard cost of capital models such as the Build-Up or CAPM.

The Multiple of Discretionary Earnings method is another choice when valuing a small manufacturing company. You can get excellent valuation results while accounting for a broad range of business financial and operational factors. To estimate the business value, this method requires a single-valued estimate of seller’s discretionary cash flow as its earnings basis.

Asset-based valuation of manufacturing business: Capitalized Excess Earnings method

A well-known Capitalized Excess Earnings method is a frequent choice to value manufacturing firms under the Asset approach. In addition to determining the total business value, this classical method lets you determine the value of business goodwill.

You can also use your valuation analysis results in order to allocate the business purchase price across the assets. Proper purchase price allocation is an important tax-minimization strategy following the business purchase.

Manufacturing business valuation – best practices

It is best practice to use a number of standard methods to calculate the value of a manufacturing company.

See How to Do It

Food service is big business. In the US alone, over 570,000 eating and drinking establishments generate nearly $375 billion in annual revenues and employ some 6.8 million people.

The industry landscape is increasingly dominated by regional or national chains which account for more than 70% of the market.

Yet the average restaurant grosses $1,200,000 and employs just 17 people. And there is still opportunity for independent restaurant owners with innovative concepts to tap into affluent niche markets, especially in major metro areas.

Approaches to restaurant valuation

As with any business, you can approach restaurant valuation three ways:

Given the diversity of businesses in the food and drink industry, there is no single “formula” to measure what a restaurant is worth. To get accurate results, you should consider a number of business valuation methods under these approaches.  

4 key restaurant value drivers

A number of factors affect what a business is worth. For restaurants, the key value drivers are these:

  1. Track record of sustainable sales growth.
  2. Stable earnings.
  3. Condition of furniture, fixtures, equipment and leasehold improvements.
  4. Lease terms.

How well the restaurant stacks up against its competitors across these key value drivers affects its value. To see how well your restaurant compares in your market, you can use a number of pricing or valuation multiples which are derived from sales of similar restaurants.  

You determine your restaurant value by applying these multiples to your gross revenues or seller’s discretionary earnings. Typically, the revenue and cash flow bases are calculated as averages over several years. Hence, if your restaurant shows stable, above average sales and cash flow, its value will be higher.

Income-based business valuation methods are very often used for valuing restaurants. The Multiple of Discretionary Earnings method, in particular, is very well suited for valuing owner-operator managed food service businesses.

Turn-key restaurants in great locations are more valuable

In addition to the four key factors above, this method lets you account for such important elements as the restaurant location, its employee base, and ease of operation. Needless to say, a “turn-key” operation is more desirable than a poorly organized business and is likely to command a higher selling price.

Condition of equipment and restaurant value

Condition of the restaurant assets determines the amount of capital reinvestment needed to keep the business running. If the restaurant requires significant investment for renovation, concept change or code compliance, the savvy buyer would discount the offer price accordingly.

High rents kill a restaurant’s value

Rent is a significant part of a restaurant’s operating expenses. Generally, rent which exceeds 10% of the gross revenues is considered excessive. Experienced restaurant buyers would discount the offer price to bring the rent expense in line with the industry norms.

Restaurant Valuation Multiples

There are thousands of restaurant sales each year. See how to estimate your restaurant value using valuation multiples derived from recent business sales.

Finding your business value by market comparison

You probably noticed that ValuAdder features a number of market-derived Rules of Thumb. The Rules give you a very effective way to estimate your business fair market value using the well-known Comparative Transaction Method.

In plain words: you determine the business value by comparison with similar businesses that have actually sold. All you need to do is select your business type and provide a few key business financial performance inputs. ValuAdder does a number of calculations to give you the business value range, average and median values.

Locate your business type 3 ways: 1. By Name 2. In Industry Group 3. By Direct Search

With over 350 major industries to choose from you may wonder what it takes to find the right industry for your comparison. ValuAdder engineers thought of this as well – and came up with several handy ways to simplify your work:

  • View Rules listed by Name.
  • View Rules organized by Industry Group.
  • Use the search engine to quickly find the Rule you need.

To see all available business types in alphabetic order, click on the By Name button and scroll to the business type you want.

To look up your business type by Industry Group, click on the By Industry button, then expand the Group view to see all related business types.

For a very quick lookup, use the built-in Search engine: just start typing the business description you are interested in. ValuAdder displays all matching business types immediately.

Now make your selection and specify your key financials such as the business cash flow, revenue, inventory or tangible assets. ValuAdder instantly displays the business value range, average and median values.

You will appreciate the time savings if you need to do a number of market comparisons: when looking for a business to buy or doing a number of what-if valuation scenarios.

If you are looking at a business valuation result that just doesn’t make sense, chances are there is a mistake. An error can creep into your business valuation in a number of ways. Here are the top ones to watch out for – and avoid when valuing your business:

1. Choosing the wrong type of business value.

Business valuation results depend upon what type of value is being measured. The most common standard of value used in business appraisals is fair market value. However, many business valuations are actually done under the so-called investment standard of value.

This is especially the case if the business is valued in order to attract outside investment, large corporate acquirors, or in cases of legal disputes. The assumptions made and, therefore, the results of business valuation under such diverse value standards can differ considerably.

2. Measuring business value against the accounting profits instead of cash flow.

Business value depends largely on its earning power. And the most direct measure of business earning power is cash flow, not net profit.

For business valuation purposes, you should use Seller’s Discretionary Cash Flow or Net Cash Flow as the earnings basis. You can estimate these by recasting the company’s Income Statement and Balance Sheet.

3. Assuming that every established business has positive business goodwill.

You may have run across this common view of business value: it is the sum of the business tangible assets and goodwill. Bear in mind though, that business goodwill is directly related to the business earning power.

The business appraiser’s view is this: business goodwill exists if the business is able to generate earnings over and above a fair return on its tangible assets.

If the business earnings fall below the fair return on its assets, then you have negative business goodwill. The well-known Capitalized Excess Earnings method helps you measure the business goodwill and total business value – directly from the business asset base and its earnings.

4. Using the wrong valuation multiples.

If there is one reason business valuations go wrong, this is it. There are a number of valuation multiples used to estimate what a business is worth. Each relates a specific measure of financial performance to the potential business selling price. Use caution when applying these valuation multiples – if the multiple is based on the business Net Cash Flow, do not apply it to its net profit!

5. Leaving out key assets and liabilities from business valuation.

Most small business transfers are done as asset sales. The seller pays off all business liabilities  and retains the cash and accounts receivable.

Typical market-derived pricing multiples are based on the asset sale assumption. If you use such pricing multiples, be sure to adjust your business value result to account for all the assets and liabilities involved in your specific situation.

As a rule, additional assets acquired by the buyer increase the business value, any liabilities assumed decrease what the business is worth.

6. Failing to assess your company-specific risk.

Risk assessment is a key factor in any business valuation. Using capitalization or discount rates that do not account for your company’s specific risk profile can lead to very misleading results. Each company has a number of financial and operational factors that contribute to its risk profile. Hence, your discount and cap rates are unique to your company.

See how to assess your company’s risk – and avoid this nasty mistake in your business appraisal!

7. Thinking that the business purchase price and project costs are the same.

If you value the business to buy or sell it, don’t forget to make several important adjustments: 

  • The business buyer also needs to inject adequate working capital. In an asset sale, this is over and above the purchase price.
  • Deferred equipment maintenance costs. Deduct these costs from the purchase price.
  • Investments required to maintain the business income stream: hiring staff replacements, regulatory compliance, licenses. Adjust your business value by the appropriate amount.

Business people often disagree about business valuation results. Given the amount of money at stake, it is not surprising that the parties tend to view what a business is worth from different points of view. Consider these common situations:

Business sale

The business seller wants to maximize the selling price and looks to support a higher business value. The buyer, on the other hand, is interested in a lower business value in order to reduce the purchase price.

Partner buyout

The departing partners would like to receive the highest amount possible for their share of the business, hence their interest in demonstrating a high business value.  In contrast, the remaining partners want to minimize the payoff, hence their desire to justify a lower business valuation result.

Tax controversy

The tax authorities are interested in showing the highest possible business value in order to maximize the tax revenue. The business owners want to reduce the tax burden and seek to show that the business is worth less.

If each side gets the business appraised, the results may be quite different. You may wonder: if a business appraisal is done to professional standards, shouldn’t the result be objective?

Different assumptions lead to different business valuation results

Remember that business valuation relies on a set of assumptions about how well the business will do in the future. This is especially so when the income-based business valuation methods are used. So, being objective means making a solid set of assumptions about the business future economic performance. But, since no one can predict the future, the assumptions made by one party to a business appraisal may be challenged by the other.

Consider just a few points:

  • A number of business scenarios can lead to different projections of income and expenses. This affects the business cash flow which is a key factor in business valuation.
  • Possible future outcomes may be associated with different business risk. This, in turn, affects your choice of the discount and capitalization rates to use in valuing the business.

It is not practical to consider all possible future scenarios. A common approach taken by many appraisers is to prepare several forecasts on which to base their business valuation:

  • Best case scenario.
  • Worst case scenario.
  • Most likely case projection.

One way you can use these projections in your business valuation is to establish a value range, from low in the worst case to high if the best case scenario prevails. At the very least this sets the stage for a reasonable negotiation.

Alternatively, you can assess the likelihood of each scenario occurring in the future. Calculate the business value for each scenario, then multiply each result by a percentage weight that reflects its probability.

Let’s say that your “worst case” scenario indicates the business value of $1,500,000; the best case gives $3,000,000 and the most likely case is $2,100,000. You consider that the most likely case has a 50% chance, while the other two scenarios are equally likely at 25% probability each. Now multiply each valuation result by its weight to get:

$1,500,000 x 0.25 + $2,100,000 x 0.5 + $3,000,000 x 0.25 = $2,175,000

Payback period is the time it takes to recover your original investment. If you are buying a small business, that’s your down payment money.

You can use ValuAdder Deal Check tool to factor in your payback period.

Here’s how:

1. Your purchase price and terms 

Enter the purchase price and terms you have in mind. Next, specify the compensation you need for yourself. Don’t forget to enter the “capital expenses” needed to keep the business running smoothly. 

2. Return on down payment 

Now, let’s say you want to get your down payment back within 4 years after the business purchase. Enter 25% into the “Return on Downpayment” input on the Deal Check Tab. This tells ValuAdder that you want to recover your downpayment in exactly 4 years after you close the deal.

3. Does the business throw off enough cash flow? 

Click on the Calculate button to see the cash flow required from the business.

If the actual business cash flow falls short, you can consider a few changes:

  • Negotiate a lower purchase price. This, of course, reduces the down payment and cash flow required from the business.
  • Lower the down payment amount. You can recover a smaller investment more quickly. Watch the debt service as you use more of “other people’s money”.
  • Increase the term of the seller or bank loans. Debt service has a major impact on the business cash flow. Generally, the longer the term, the less cash flow is needed to service it.

Caution: You and your business must be paid! 

Don’t reduce the amount of capital expenses, working capital or your compensation level. You will need to buy new assets and replace old ones as they wear out. And you must pay yourself to meet your own expenses.

Keep the ValuAdder AutocalculateTM on – it will save you a lot of time as you fine-tune your business purchase terms.