Archive for the ‘comparables’ Category

More About Comparables

Thursday, March 6th, 2008

In my last real post I talked about some of the problems with using comparables, namely that there is not enough information in most datasets to determine how comparable the data really is. It’s a bit like trying to value an orange by knowing the price of 30 small round fruits.

Comparable values often can give you a range of multiples that is so broad as to be meaningless. In a comparables report that I ran for Mfg. – Fabricated Metal Products with sales between $1,500,000 and $2,500,000 I got an average cash flow multiplier of 3.21, and the median was 3.52. “Great,” you say, “so my metal fabrication business with cash flow of $1,000,000 is worth about $3,333,000.” “Not so fast,” I reply, “the range of multiples in the report was from 0.16 to 5.27, so your business is worth between $160,000 and $5,270,000 – quite a range.”

Further complicating the use of multiples is that unlike in real estate deals where comparables are often used, in small to mid-sized business transactions the deal is seldom all cash. When a comparable is reported it may not be clear what the true value of seller provided notes, earn-outs, restricted stock, contingent payments, and so on really is.

There is, however, one big advantage to using comparables. Comparables represent real world transactions. So, if you are going to use comparables, how do you go about doing so in a way that minimizes the problems that we’ve discussed? The answer has two pieces. First, use comparables as only one method of valuing your business among several. Second, select a good source of multiples data. The best source is a business broker that can use past transactions of his own as a source of data. The broker will be aware of how the deal was structured and how similar your business is to the comparable. If you don’t have access to an experienced professional to help with the valuation, has data that is more comprehensive than most. For example, the data includes a field for the percentage of the deal paid in cash at closing. Alternatively, if you’re considering selling perhaps it makes sense to talk to a broker. You can use our website (shameless promotion here) to get up to four proposals from pre-screened business brokers. Ask them how they’ll help you determine an appropriate asking price.

The problems with using comparables as a valuation methodology

Saturday, February 9th, 2008

One method of valuing a business is to use comparables. In the world of small businesses, this is often a mistake. Let’s look at some of the reasons why.

I ran a report from a prominent data provider (who now offers free valuations based solely on these comparables) at the request of a buyer who was purchasing non-emergency medical transportation companies. Let’s look at some of the issues with the report. To begin with, although the data provider was a reasonably large player and the database contains about 17,000 transactions no category narrow enough to match what my buyer was interested in, so we ended up using a category titled “Services – Local Passenger Transportation.” We got a result based on 34 sales over a 5 year period, a period that included wide fluctuations not just in the market for small businesses but also in things like the price of gasoline that had disproportionate impact on this industry.

The average Cash Flow Multiplier was about 2.4, the median was 1.9. So, could my client conclude that a seller who was asking 1.5 times EBITDA was a bargain and one who was asking for 3 times EBITDA was asking top dollar? Not really. If we look at the descriptions and limit ourselves to transactions that had occurred within the last year, we find only 2 transactions are left, not enough to base any real conclusions on. Their multiples of cash flow were 2.47X and 3.64X.

What is more important than what we know about these companies is what we don’t know. In this report we have no idea how strong the balance sheets of each company was and medical transportation is a capital intensive business. Even if we had the balance sheet, there are many things that can affect the numbers on that balance sheet making two balance sheets hard to compare without an in depth analysis. For example, choosing a different method of depreciation can materially affect the value of the balance sheet.

There are also things that are never reflected on a financial statement. A business in a rural area will sell for less then one near a major city. A business that is growing is more attractive than one that is not. Unless you know a lot about the businesses being compared you can’t decide how relevant the information is.

Most business comparable reports don’t contain enough data to allow a reasonable assessment of true value. It’s like trying to assign a value to a house based only on the square footage, the number of bedrooms, the number of bathrooms, and the fact that it is in Los Angeles. To get real value you would need to know what shape the house was in, what neighborhood, etc. Anybody who tries to value a home on the basis of broad averages would be laughed at. Unfortunately, businesses that are even harder to value fairly based on comparables are often valued in just that way.

In the next post I’ll talk more about the problems with using comparables to value a small to mid-size business and the one after that I’ll talk about where they can be useful.