If cash is king in business, then an accurate picture of business earnings is king in business valuation. That’s because business value is all about the company’s earning power and risk.
It goes without saying then, that a business with a history of superior earnings is more valuable than its less profitable industry peers. Investors delight in companies posting a healthy profit while enjoying the benefits of a protected market niche. Think exclusive supplier contracts, major customer agreements, or innovative technology covered by patents that keep the competitors out.
Unsurprisingly, most business owners would like to put their best foot forward by showing outstanding financial results. The situation gets even more interesting if the company is privately owned.
Public companies must disclose their financials – warts and all
In the developed market economies, publicly traded companies are required to report their financial performance regularly. This way the investors are aware of what is going on and better able to assess the risks and likely returns on their share of the business.
Standards abound to make sure you can run an ‘apples to apples’ comparison – from GAAP and IFRS financial reporting guidelines to quarterly and annual reports detailing the current and anticipated business risks. The law looks after the investors who are not business insiders.
Key benefit of standard financials reporting – consistent valuation multiples
So when you talk about a measure of business earnings, say EBITDA or Net Income, all public companies report the numbers in the same manner. To compare the value of your investment in one firm, you can develop a number of valuation multiples relating the business enterprise values to your favorite financial performance metric. Say hello to the price to earnings (P/E ratio), price to EBITDA, gross revenues or net sales. You get the idea.
But step into the murky world of privately owned companies and the plot thickens. Since such businesses do not sell their stock or debt to the public, they are not required to provide detailed reports of how well they are doing. The name of the game here is to maximize the returns for the existing business owners while keeping the tax burden down.
Caveat emptor – creative addbacks and apples to oranges comparisons
The net effect is that the valuation multiples you come up with by looking at a private company No 1 may be misleading when applied to valuation of a private company No 2.
Take an example of the EBITDA earnings measure. A company may decide on an aggressive cost recovery policy to depreciate its assets rapidly. In addition, it may be able to borrow on ‘sweetheart’ terms from an affiliated business or even owners themselves thus reducing its interest expense. Private companies are often organized as the so-called pass-through entities and do not pay any income taxes directly.
To use the price to EBITDA multiple in your privately owned business valuation comparisons, you would need to know what the real depreciation of business assets is, whether the company’s management is deferring essential maintenance and equipment replacement in order to create an overly rosy picture of profits, and whether the company is borrowing at market rates.
If you decide to value businesses based on the seller’s discretionary earnings or SDE, beware of creative addbacks used by the owners or their brokers to overstate the company’s cash flow generating power.
Due diligence to the rescue: when in doubt, dig!
Question the principal owner’s total compensation package. Check into the outgoing management team’s compensation to see if they can be replaced at the current market rates. It is not unusual to find the situations of ‘sweat equity’ where the owners work for less than they should be paid, or ‘gravy trains’ where family members get a paycheck for very little work.
Many private businesses own some commercial real estate and keep their rental expenses artificially low. Rental costs are a significant part of business operating expenses. New business owners may find that negotiating a lease on the terms available to the outgoing management team is not feasible. The effect is a hit to your profits the moment the business ownership changes hands.
If assessing a private company’s earning power and risk looks like a challenge, it is. Doing adequate due diligence in order to uncover what makes the company tick is your best defense against a bitter disappointment down the road.