Whether you are a buyer or a seller, it is important to be able to evaluate a business purely as an investment. There are essentially two kinds of buyers: those who expect active involvement in the business and compensation for their labor, and those who expect to be passive owners, who are looking for a return on their investment. Both types need to ensure that what they do not personally bring to the business will be covered by the business itself.
Aside from understanding the operations of a business, one of the most significant issues to evaluate is the return on your investment. To do this, a “capitalization rate” is applied to the cash flow (see this previous blog post for a description of cash flow). This capitalization rate applies an estimate of a rate of return to determine how quickly the investor can expect to recoup the investment.
Determining the right capitalization rate to apply to a business requires some knowledge – either of the dynamics of the industry itself, or access to information related to the industry. Business appraisers have access to data and ways to determine a meaningful capitalization rate for an industry and can provide objective expectations based on historical capitalization rates for the industry adjusted to current market conditions.
Despite theoretical capitalization rates, the real issue to consider is how the investor will look at the opportunity. Part of the thought process for understanding the expected rate of return (capitalization rate) is the idea of the opportunity cost of investing in a particular company versus investing somewhere else. The two considerations are the “return on capital” and the “return of capital.” In short, an investor will want to receive a current return of at least a “risk free” investment. But his only way to mitigate risk is to receive a return of the total investment in an acceptable period of time. This will ultimately determine the acceptable capitalization rate for the buyer. In concept it’s simple. If the buyer wants the equivalent of a risk free 5% return, and wants to recover his investment (pre-tax) in five years (20% per year), then the acceptable capitalization rate will be 5% plus 20%, or 25% total. The normalized adjusted net operating cash flow is normally divided by the capitalization rate to determine the value. A particular buyer’s acceptable capitalization rate may be significantly different than one derived by an appraiser. It is his personal standard. That is why an appraised value is really the most probable value for a sale within a range of possible values.
It is actually easier to use the inverse, or reciprocal, of the capitalization rate, which becomes a multiplier. So if the cap rate is 25%, the inverse is 4.0 (1/.25) and the value would be 4 X the normalized adjusted net operating cash flow.
At a minimum, a company should be expected to produce enough cash flow to provide a reasonable return on the fixed assets. Any cash flow beyond this minimal level is called “Excess Earnings” and is applied to the intangible asset value. This is a way of determining the goodwill value.
Other items to review include inventory and accounts receivable. It is important to understand the inventory situation (if applicable to the company). This includes calculating inventory turns and understanding the amount of obsolete inventory. Companies with low inventory turns tie up their precious cash in non-productive uses for longer than necessary. Similarly, companies with a history of collection issues and/or receivables that are left in aging too long are not maximizing their cash position. Both inventory and receivables can add or subtract value depending on how well they are managed.
To show maximum investment value requires thorough documentation in an Offering Memorandum (or Private Placement Memorandum). This is usually prepared based upon an appraisal, but contains other information relevant to the investment potential.
In summary, a business is basically an intangible asset, though it may contain some tangible assets. The perceived value depends on how well the intangible aspects are shown to have value.
Post by: Gerald W. Barney MS, CSBA, CMEA
American ValueMetrics Corp.