Beyond the Multiples - Part Two: Income Approach to Valuation
In a prior life, I was involved with M&A work in the oil industry for ConocoPhillips, and I saw many substantial deals at least get narrowed down to the final few buyers simply based on 8X net cash flow. This seemed to be an industry standard unless there were unusual circumstances involved. Don’t get me wrong, management required a thorough discounted cash flow analysis before final approval (no need to sell your oil stocks!), but there was some validity to using rules of thumb. In the last issue, I mentioned that there are three widely used methods for valuing privately held companies – the asset, income, and market approaches. In this article, I’m going to discuss the income approach in more detail.
Income Approach Theory
The theory with the income approach is that an investment is worth the value of the expected future income discounted back to the present at a discount rate appropriate for the riskiness of the investment. For privately held businesses these discount rates are frequently in the 20-30% range to account for the inherent uncertainty associated with many private companies.
The challenge with using future income to measure value is coming up with a reliable forecast. If you’re really good at accurately forecasting profits of a company then you might have a lucrative future on Wall Street. Since most of don’t have a crystal ball, we rely on either historical financial performance of the company or realistic, supported projections – or a bit of both. The reasoning for using past performance is that it’s fact, and although it’s common practice to base the value on results over the last twelve months, it’s also a good idea to look at the longer term trends - ideally a full business cycle - to see how the company performs in both favorable and unfavorable conditions.
For most established companies, past performance is the best indicator of future performance, unless there are specific, tangible reasons to believe otherwise (new markets, products, patents, contracts, etc.). Business owners often tell me that the value of their business should be based on “potential”, and even though it might be a 20 year old company with flat growth, they believe all the new owner needs to do is increase marketing or hire a couple of sales reps and profits will skyrocket. There’s also the case where a company has grown profits 20% per year for the past few years, and the owner believes the value should be based on similar growth in perpetuity. To put that in perspective, 20% annual growth implies the company will be 6 times its current size in 10 years. Sustainable, supported, and realistic forecasts are essential for deriving a sensible value.
The exception is the case of early stage companies and those going through a turnaround. In this case, projections will be relied on more than the past, obviously, but you can also expect a higher discount rate because of the higher risk involved with forecasts that are not based on historical performance. So the more you can prove the market potential – even if it’s just a few years of growth – the more valuable the company is going to be. For you Shark Tank fans, this should sound familiar.
The other part of the equation is determining what income stream to measure. EBITDA (earnings before interest, taxes, depreciation, and amortization) is commonly used because it allows for comparison between similar companies regardless the capital structure or tax strategies employed. However, multiples can be applied to a variety of benefit streams, including revenue, gross margin, operating income, or net cash flow depending on the industry and situation.
So how do discount rates and projected income relate to the multiples? The simple answer is that the inverse of the discount rate minus the growth rate is the multiple. For example, a 25% discount rate applied to a company with 5% long-term, sustainable EBITDA growth equates to a value of 5X EBITDA. For the mathematically oriented, that’s 1/(25%-5%). Yes, discount rate minus growth rate is a capitalization rate – commonly used for real estate valuation. The only complexity in applying this to business valuation is that income from most companies rarely grows in a linear, predictable fashion, but the concept is the same (that’s also why Excel has a NPV function).
Multiples are great shortcuts to value, as long as you understand what they represent. Be realistic about your assumptions, and don’t be afraid to validate them with feedback from others. In the next issue, I’ll address the maze of market comps and how they can be used to make meaningful comparisons.
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