Ep. 22 - Valuation Techniques: Art or Science?

Discover the main valuation methods for buying or selling a business, and learn how to determine the best approach, understand valuation multiples, and enhance your business's value in our latest podcast episode!

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TRANSCRIPT:

Welcome to Integrated Insights with ICCG. For more than 30 years, our team has partnered with small business owners to prepare for and navigate the business transaction process.

Pull up a chair as we share stories and insights from our experience on all sides of the M &A table. And welcome back for another episode. My name is Michael Hefner.

I will be your host for today's episode of Integrated Insights. I'm joined by a couple of the team members and my co workers, Andrew McQuilkin and Mason McFarland.

Welcome guys. Thank you. Thanks. Today, we're going to be talking about valuation strategies, art or science. And so to get started,

let's just talk about what What do we mean when we say valuation and what are the current methods used today? Well, first let's explain how this is different from a business evaluation or valuation that you kind of hear about because I think owners come in and they say I've got a valuation on my business and that's not what we're talking about today.

We're talking about when you come to us to sell your company, we look at three different approaches that are used in in evaluation of your business and so there's an asset approach which I would say is typically used if your company has equipment trucks all that kind of stuff if that exceeds the value of your business or what's on your bottom line and a multiple of that,

that's typically when you would use an asset approach. And then there's the market approach, which is typically what we see and what we use. And I think there's a lot of things that affect it,

but basically it's using the EBITDA or the earnings before interest, taxes, depreciation, basing the value off of that, off of some sort of multiple of that.

And it's, I think the factors are, you know, economic factors, industry trends, all that kind of stuff. It's what buyers are willing to pay for certain industries kind of sets that,

that multiple and that valuation. And then there's the future income approach, which we don't work a lot with. But it's, it's basically if you've got contracts,

and yeah, Andrew, do you want to speak to that? Yeah, the future income is, honestly, it's about the predictability of the sales or predictability of the cash flow of the business.

And so, if it is heavily subscription, right? Software as a service, SaaS companies are notorious for this method just because it is extremely predictable.

And you have people sign up for months and months and months, maybe years, and it's heavily predicted.

And so you kind of use, it's a similar to market approach, but it kind of maybe even a multiple of the revenue, right? So for what,

where we have come across this mostly, majority of the time, whenever we do use it, really is in pest control,

right? And so you think about not the termite side, not the, hey, I've got a raccoon in my chimney, I got to get it out. Not that side, it's the recurring maintenance,

hey, I'm gonna spray for every quarter every month or whatever treatment that kind of side That's predictable and and so we we we use this and and look all all the valuation methods The the it's all it all revolves around what Kind of return there's going to be in the company,

right? If you buy this company, it's all about what am I gonna, how long am I gonna get my investment back, right? And so for, same thing with the market,

the market approach where you're putting multiple, that multiple is based on the kind of return that you're going to make. And so,

I know we've And a couple videos on this, you know, I think that we can research a past video that we can drop where even, I think, Grant and Dave,

they speak to this of just kind of the return side of things and the valuation. But that's essentially what we're trying to do.

And there are several factors into all three approaches, right? - So I know like for the asset approach we talked about when assets are worth more than the business,

is it that black and white? Is every business different? What other factors kind of contribute? You know, you said that we don't really use a future income approach much, but is it black, is it that black and white asset approach versus market approach?

- Yeah, you know, I would say it's probably more black and white than it is gray, but at the same time, I mean, look, we actually look at both approaches.

We look at what is the cash flow, and if it's not cash flowing at all, then, well, it's probably Right if there's if just because it's not it's not producing so if you try to put a multiple on that and that net number You end up with a negative,

right? And so it's it's worth what you're going to It's more of the replacement cost, right of Buying the assets that you have right it's heavy equipment type of businesses and And so,

you know, that's when you decide it is an asset. When I say we look at both, let's say a company is,

I'm just going to use numbers that I can compute, but the net number is 100 ,000, right? And that's the number that we're going to put a multiple on.

Let's say that multiple is three times. So it's a $300 ,000 company. But if the assets are much greater than that,

then we would, you know, if the, you know, I say, and I'll also say net assets, right? So that means, That means the value of your equipment,

right, minus all what you owe on it, right? And so that's what that net assets are, and you kind of look at that, okay, well that is 750 ,000,

okay, well, then now you're looking that, I mean, if you sell all your equipment, then you're going to get $450 ,000 more than you would if you sold the company just based on market approach.

Yeah, Andrew, I love that you brought up net assets there because I think that's really important to highlight in that original explanation of the asset approach because it's not just the assets are more than the business,

but the net assets are more than the net net of the entity. So the tax structure can impact that. We would have dug into that more on the structure episode that Grant was on previously.

But I think that's really important for our listeners to hear. And another thing that you also mentioned there, Andrew, though, was the multiple that is applied. So let's dig into that a little bit more 'cause I know even internally when we're trying to evaluate a business's current standing.

One of the things that we do is we do some research, we figure out, hey, in that industry, what is kind of the range? What's the spectrum of multiples that we see? So what can affect where a business lands on that multiple spectrum?

- Yeah, there are a lot of things that can affect it. I think One, just the overall business is reputation. I think having a lot of products and services with a steady revenue stream can affect it positively.

Having an experienced management team and not being dependent on the owner to be able to run it, that would increase the multiple.

and you would get a higher end on the multiple range. But, and yeah, just a buyer looking at does this business have growth opportunities as well?

Those are just a few things that can affect the multiple in a positive way as a buyer's looking at it. - Yeah, and I would say, I mean, the factors, there are a lot of them.

And That's why we dive in pretty deep so that we can know what the factors are, right? So there are the discounts to it,

right? If it is heavily dependent on the owner, like Mason said, but there are very specific ones that we have to dive into and that's why we're going to ask you a ton of questions,

right? And so, and, and I would also say, I mean, there, there are ways that we could, we could talk through it and even hopefully really kind of almost,

you know, advise you to, to fix it before you, you take it to the market so that you can up your value, right? And that's, those are, there's several ways to do it. It's not just a,

I need to be increasing, I need to be, I need to increase it a little bit more. It's not just about that. It is about a lot of these different factors. It's about the, the, the, the profile,

the overall profile. And so we, we will dive into just to look at all of those factors. And we, that said,

I mean, there's even in, even in each There is it. There is its own range, right? And those that are that are in the construction industry they're not trading at the same level of a of a Airspace and Defense company will say right or or even a healthcare company They're they're not the same and so and so the ranges It could be,

hey, we're going to be at three to four and a half, and then over here, we're going to be at seven and nine, right? And so it really is,

it's going to depend on that, and then we go into the details of where you are in that specific range, too. That's great.

Andrew, I'm - Andrew, gonna put you on the spot for a second. I know something else we look at when we're trying to determine, hey, what is the value of this company and applying to EBITDA all that? We also look at the way to look at trends,

how they're doing, some of it's just like an average of the last three years, some of it's weighted. How do we come to a decision on that? What impacts if it's weighted versus average versus just the last year?

Yeah, that argument for what the multiple is going to be on, right? We say multiple of EBITDA, what is that EBITDA,

right? And so, and it's not just a one calculation. I mean, there are adjustments that we may make, right? One -time expenses that aren't normal or really abnormal expenses and you know maybe it's hey this happened in this company this last year that's not gonna happen for another 10 years whatever it is right so they just did this big repair in the in the building or or to some of their equipment or whatever that

looks like but we have to adjust some of that kind of stuff some of that stuff and and really that is that's the first thing that we'll do right and then we'll also say okay what's what is the like you mentioned average the weighted average is what we we say a lot of times so that means we kind of look at the last three years,

this is one quick formula that we'll do, but we'll take, so it will take 50 % of this most recent 12 months,

30 % of the previous 12 months, and then we'll take 20 % of that, the previous, not one. And so you kind of take that,

and that is what the multiple would be on. That's one way of calculating a weighted average, if you will. We will, it really just depends on several different things but yes,

trend is a big one. A lot of companies after COVID, they declined and they showed that kind of trend and we kept on walking through what it would look like if you showed a hockey stick,

all right, and the longer that you get that hockey stick, the more likely the method would change in what EBITDA we're using.

Is it a trailing 12 month? Is it awaited? Is it just average, you know, what does that look like? And so, I would say, honestly,

most companies that are trending upwards, and they are pretty stable, they are growing,

and there's a pretty solid profile of the company, I would say that it's, I have seen most commonly that it's a multiple of a trailing 12 month.

If there's seasonality, if there is kind of up and down growth or an up and down trend, then I would say we've seen a weighted average,

We've seen an average, it just, that's what I have experienced and this may not be the case for everyone, but what I have experienced in the last few years has been more of,

if it's up and down, but there's still kind of a, almost, you know, you put it, put over, you know, several years worth and they're still kind of a linear growth,

but it's just going like this, it's probably going to be a weighted average, because you put a little bit more weight on the most recent, what has most recently happened,

right? And so, if it's just straight up and down, that's when we would say an average. If there is even a decline and a hockey stick growth,

we probably would do an average then because we know that it's trending back up. That's a lot of people after COVID, that's what they kind of looked at.

But the further along they got where they showed that growth Um, they would more likely be just a trailing 12 month,

um, EBITDA. And so that's, that's, I mean, it, it really depends on the buyer buyers differ. I mean, for Saint one deal, I got,

I think I had, um, five different methods on, on, on how they calculated the EBITDA to put a multiple on. So And really, you just don't know a lot of times,

but yeah, most commonly trailing 12. Well, before we wrap up, just a quick message to our listeners. One thing that you can do to get to start positively impacting that multiple today is to get your house in order.

Make sure your finances are tight. Make sure they're consistent. Grant has said on the broadcasts before that it's better to be consistent than right. So get somebody,

whether you got to outsource it or you have someone in -house that you trust, get those financials in order so that trends can be seen and that you can get the most for what your situation truly is.

Look, I think that an advisor has the ability to point out a lot of the negatives, right, and points out the positives, but the main thing is let's point out the negatives so that we can maybe change some of those things.

That's a big reason of why you came in advance. Yeah, not to question the trust of business owners, but sometimes just because you have a trusted advisor doesn't mean they should be trusted, right?

So if you have that question, you say, "I have someone managing it, but I don't know if it's managed the way it should be. Like we're happy to sit down with you, look over those financials, kind of tell you,

tell you what you're looking at and where some changes may need to happen. So awesome. Well, Andrew Mason, thanks for joining me today. That's all the time we got. And that wraps up another episode of Integrated Insights with ICCG.

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