A Valuation Carol: Our Secret To Business Valuations
Our Secret To Business Valuations is all about asking the right questions.
Should we be really be giving away our secret to business valuations? YES!
GHOST OF VALUATIONS PAST
The best place to start the due diligence process is getting a sense of where the subject company has been in order to see where it’s going! Oftentimes, a company’s past will give you a glimpse into the future.
It is important to document and understand key events in a company’s history.
Explore the details:
- When was it founded and by whom?
- Create a timeline of the company’s key events and initiatives.
- Gain an understanding of where the company experienced success and how it capitalized on its successes.
- How did the company react to adversity?
- Find out how the company has adapted to changes in the economy (e.g., downsizing when appropriate) and the industry (eliminating or introducing products).
GHOST OF VALUATIONS PRESENT
THERE’S NO “I” IN TEAM
The analysis of present day operations are equally important. One of the driving forces of a company’s success and therefore, value, is the capability and depth of the management team. A strong, deep management team is a vital cog in driving value. Delve deeply into the make-up of the management team. Determine how the management team was selected (was the position earned or inherited). Ask about the management teams’ backgrounds and experience.
The age of the management team is also a factor to be considered. The appraiser needs to examine the company’s succession plan. Does the company have either a formal or informal plan in place? Find out if the company is proactively grooming employees that could potentially fill management roles. If no internal candidates are identified, ask if the company intends to conduct a search for outside prospects.
Inquire about the board of directors (“Board”). Are the management team and the Board one and the same? Does the Board include outside members that are willing to challenge the management teams’ decisions when necessary? Do the backgrounds and experience of the Board members make them an effective sounding board for management?
WHERE, HOW & WHO
Understanding the impact of the company’s geographic market is important. If the company’s geographic market is concentrated, it makes sense for the appraiser to find out how the changes in this market’s conditions will impact the subject company. It’s also important to determine if the company can (is it contractually limited to a certain territory) and has the capability (does it have the necessary personnel or facilities) to expand geographically. Not to be forgotten are the different set of risk factors to be considered if the company’s geographic markets extend overseas.
The same is true for the company’s target markets. Is the company focused on a particular industry or does it serve diverse industries? Determine if the industries it serves experience different cycles to understand if a downturn in one might be offset by an uptick in another. The company’s outlook is tied into the expectations of the industries it serves. Find out if the company serves a mature industry with limited growth potential (printing) or will benefit from fast growing industries (healthcare related).
How does the company sell/market its products/services? Does the company employ an inside sales force or does it depend on independent representatives or distributors? It’s good to know what motivates the sales reps. Are they salaried (could lead to complacency) or commissioned? What are the arrangements with the independent reps and distributors? Ask how sales are generated: is it through advertising, word-of-mouth, referral sources, the Internet? If advertising is the primary method of acquiring customers, is the company putting its marketing dollars into the most effective vehicles (replace direct mailings with e-blasts)? How does the company’s website fit into the marketing plan? Is it updated and user friendly? Is it informational only or can orders be placed through it? How does the company follow up on Internet leads? Find out how the company incorporates social media into its marketing plan.
Know if the company has high customer concentration (get list of customers accounting for 5 percent or more of annual sales). A company’s risk increases as the number of customers on which it depends decreases. A company whose top customer represents 65 percent of annual sales has a very different risk profile than one whose top customer represents 5 percent!
THE OTHER GUYS
Most companies face some level of competition. So, the appraiser would be remiss if he/she did not ask about the state of the subject company’s competition. The logical place to start is the number and size of the competitors followed by more detail on how the subject company competes (is it on price or service). The health of the competition is also pertinent but may be harder to determine. For companies involved in the competitive bidding process, a telling statistic may be its bid/win ratio.
WHAT ARE THE NUMBERS TELLING US
It’s easy to see the company’s sales and earnings trends from the historical financial statements provided but finding out what’s behind the numbers can be more challenging.
The appraiser needs to ask how the company achieved the sales levels it did. Has sales growth been organic or achieved through acquisitions? Ask about the impact the economy and industry have on sales. It may be that the company experienced issues internally that impacted sales (e.g. product defect). The appraiser’s job is to find out what the issue was, the extent to which it impacted sales and the resolution.
The importance of gross profit cannot be overstated. What factors are impacting cost of sales? Has the company faced significant increases or decreases in raw material costs? Has the company faced shortages in material/supplies that have pushed up prices and/or impacted the company’s ability to fill orders? How has competition impacted margins?
Compare the level of operating expenses from year-to-year and ask about large swings in any line items. This will help the appraiser to identify any potential adjustments to the income statements (any non-operating, non-recurring/atypical or discretionary expenses). The appraiser needs to ask about the responsibilities of the shareholders’ and their family members to determine if their salaries and benefits are commensurate with their duties and are in line with companies of similar size.
The balance sheet prompts its own set of questions: why the change in accounts receivable? Are there any issues with their collectability? Does the company maintain the proper level of inventory? The appraiser must also question management to determine if any assets on the balance sheet are not necessary for the company’s operations (non-operating assets or assets that would remain with the seller if the company was sold).
The company’s level of working capital and its capital expenditures should also be explored. A normalized level of working capital is required. Also, deferred equipment or delayed facility upgrades can impact future cash flow and value.
GHOST OF VALUATIONS FUTURE
This is what we sometimes refer to as the “crystal ball” portion of the due diligence meeting.
First, request the cash flow/income statement projections for as many years as prepared by the company. The response can range from management never prepares projections to receiving five years or more of detailed projections. To determine the reasonableness of management’s projections, ask about the underlying assumptions and the comparison to the company’s recent performance. Do the projections reflect expansion of existing markets, new markets, or introducing new products or services?
As a wise man once said, the only thing we definitely know about projections is they are going to be wrong! That being said, the appraiser should get management’s level of confidence in achieving the projections (are they pie in the sky; did management sandbag). It is also critical to determine if management has performed a sensitivity analysis to see what impact economic or industry events could have on their projections.
If the company does not prepare projections, the appraiser should at the very least get management’s input on where they think sales and margins will be in the near-term and the long-term outlook.
Last but not least, ask management if the company’s existing and contemplated technology, equipment and facility are sufficient to meet the company’s sales and earnings expectations.
THE FINAL NOTE
There are no stupid questions when trying to gain the in-depth understanding of a company necessary to prepare a reasonable, supportable valuation of it. A business valuation is a forward looking exercise. Understanding the company, its reactions to changing conditions, the reason for its trends, its strength, weaknesses, opportunities, and threats, and its outlook are key in the business valuation process.