Business Valuation Case Study: Cash Flow is King

Several of my previous business valuation articles have stressed the importance of cash flow available to an investor/purchaser of a business. I believe this measure of cash flow should be the primary determinant of value in most business valuations. Several years ago, I was engaged to help determine the value of a 100% ownership interest in a sole proprietorship for use in martial dissolution proceedings. The valuators for both sides were charged with determining the value of the business for asset dissolution purposes. The proceedings in court, and a comparison of the valuation methodology used by both sides present a great example of the importance of cash flow in determining the value of a business.

Case Background

The business in question was a sole proprietorship that provided “sales, repair, and installation” services to homes and businesses. The business operated out of a 2,500 square foot shop located at the owner’s residence. The business did not pay rent for use of the facilities, did not pay a salary to the owner for his services, but did pay a small wage to the spouse. The business had a consistent revenue stream, but profitability varied year to year.

Approaches Used

The opposing valuation expert (Expert A) relied solely on the Privately Traded Guideline Company Method to determine the value of the business. Expert A used the Pratt’s Stat’s – Private Company Merger and Acquisition database to search for transactions involving companies deemed similar to the subject business. Using search criteria of similar NAICS codes, a comparable range of revenue, and a timeframe of the previous 10 years to the effective date of the valuation, Expert A found 38 transactions involving companies deemed comparable to the subject business. Using these 38 transactions, Expert A determined that the mean (average) sales multiple was 0.73. Expert A then multiplied this sales multiple by an average of the previous 3 years sales to arrive at the estimated enterprise value of the business of approximately $432,000.

I also used the Privately Traded Guideline Company Method in my valuation, and the same historical data as Expert A, but made normalization adjustments to the income statements to account for the market rate rent expense for the shop, estimated market level compensation of the owner based upon services performed, and removed compensation paid to the spouse which would not be required for operation of the business. I also used the Pratt’s Stat’s database and similar search criteria. My search resulted in 40 transactions which included all 38 transactions that Expert A used. In addition, I chose the Seller’s Discretionary Earnings (SDE) multiple and the sales multiple as the two multiples to use in my valuation. According to Pratt’s Stats FAQ, it defines SDE as Operating Profit (Earnings Before Interest and Taxes) + Owners Compensation + Depreciation/Amortization. I believe that SDE closely resembles the earnings stream available to a purchaser of the business and thus is the more relevant multiple.

By way of example, my report stated,

“If you have two similar companies that both generate $500,000 in net sales annually, but Company A produces cash flow available for distribution to an owner of $150,000 while Company B produces $25,000, Company A will be more valuable than Company B regardless of the top line revenue. Using a net sales multiple alone does not account for the differences in profitability of the companies in the sample, unless the revenue multiple selected represents comparable profitability to the subject company.”

I calculated the normalized SDE for the subject company (considering the normalization adjustments discussed previously) and then calculated the SDE as a % of sales for the subject company. This percentage was then compared to the SDE as a % of sales for the transactions in my search. The results were the subject company’s normalized SDE as a percentage of sales approximated the SDE as a % of sales in the 21st percentile of the transactions in my search. The SDE multiple for the 21^st percentile associated with the transactions was 1.93 times SDE. I also calculated the sales multiple for the 21^st percentile which was 0.41 times revenue. By using these two multiples to calculate the estimated enterprise value of the business, the end result was approximately $145,000.

Analysis

My approach considered the bottom line cash flow available to a potential purchaser of the business and used multiples corresponding to transactions with similar levels of cash flow. My report highlighted that top line measures of profitability, such as revenue, should be supported with an analysis to show its relationship with bottom line cash flow measures. Simply put, if the “mean” multiple for revenue should be used, then the bottom line cash flow available to a purchaser of the business should approximate the “mean” cash flow of the data set. Within these transactions it did not, and I believed a different multiple should be used.

Findings

The judge on the case heard arguments from both sides and due to the disparity in results called for a 3^rd independent valuation expert to review both reports and state to the court which approach they believed was more credible. The 3^rd expert testified that they would have valued the company using a bottom line cash flow approach that considered normalization adjustments similar to ones used in my report. When asked if they would have used the “mean” revenue multiple, they stated that they would only have used it if the bottom line cash flow approximated the “mean” of the data set for the transactions considered. The judge ruled in favor of my valuation report.

Visit our webpage for more information on McKonly & Asbury’s Business Valuation Services. Should you have questions about the importance of the cash flow available to a purchaser of a business, or business valuation in general, don’t hesitate to contact me, T. Eric Blocher CPA, ASA, CVA at eblocher@macpas.com.

 

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