Using a Value Component Assessment to Identify, Manage and Grow Value
Co-author – Harold Floyd, Business Growth Advisor, DVIRC
Co-author – David K. Bernstein, Principal, RLS Associates
Studies show that for most private business owners the value of their business is a strong majority of their overall personal assets, often as high as 80% of their total net worth. Therefore, it is critical that owners maximize the value of their business and actively monitor their progress. Monitoring the value of a stock portfolio is easy, but how can they do that with a private business?
DVIRC has developed a Value Components Assessment Tool that identifies 28 key drivers of business value from the perspective of professional and strategic buyers.
This article, and future ones, will discuss aspects of the Assessment that are most important to leaders that are interested in taking their business value to new heights.
The first and most numerous of the 28 drivers are connect with FINANCES. Not all of the drivers are of equal value, with some rated low (1 or 2 on a scale of 1-5); four of the seven finance items are considered very important so they are ranked either a 4 or a 5.
Three of the seven are connected with a financial term called EBITDA. EBITDA stands for Earnings Before Interest Taxes Depreciation and Amortization. Depreciation and Amortization are excluded because they are noncash charges to the income statement. While they are real cash charges, Interest and Taxes are also added back because the level of those expenses will depend upon the new owner’s personal situations, which vary based on the amount of debt and their capital structure.
Therefore EBITDA is a measure that approximates the free cash flow of the company (before financing and capital expenditures) that a business is generating, and obviously the more cash flow generated the more valuable the business is, just as with any other asset!
The three drivers of business value connected with EBITDA are 1) the dollar average of EBITDA over the last three years 2) EBITDA as a percent of sales and 3) the trend in EBITDA dollars over the last three years. For some companies, the dollar average of EBITDA can approximate the value of the business as an investment for a financial buyer through a multiple of those earnings. The multiple generally increases depending upon the size of the EBITDA, particularly when those earnings get over $2MM but especially as they get over $5MM. Since there are fewer large companies than small companies, the law of supply and demand and the inherent belief that larger companies are more predictable are is why the multiple increases.
EBITDA as a percent of sales is heavily weighted because it indicates the extent to which cash flow will increase if the buyer can accelerate the growth of the company. The higher the marginal EBITDA %, the more dramatic the improvement of cash flow from growth is. Also, it is a very clear indicator of how “special” a company is perceived to be in its market niche. A firm with low EBITDA as a percentage of a sales is typically one that has few competitive advantages, orthat has not capitalized on those advantages.
Finally, and obviously, a firm with growing EBITDA would indicate a firm that seems healthy and well managed.
Also connected to the income statements is gross margin. The Value Components Assessment measures the trend in gross margin – growing, stable, declining – which is also an indication of the financial health and market strength of the firm. Flat or declining margins, absent a certainty that they can be reversed, are a major detriment to business value.
Another heavily weighted financial item is revenue trend. A firm with a recent multi-year history of growing revenues is one that is inherently more valuable than the reverse.
A moderately weighted financial item is capital expenditures as a percent of sales. In the context of business value, a firm that requires heavy capital expenditures to sustain its growth is one that is less valuable compared to one that does not have a similar requirement. This is because more of the EBITDA/cash flow has to be paid out for equipment and other things as the company grows rather than providing returns on investment to the owner(s) or being internally reinvested to further accelerate growth.
The final component of the seven financial items is the fair market value of fixed assets as a percent of sales. This is the one financial component that is low rated, only a 2 on a scale of 1-5. EBITDA cash flow to the owner is typically most valuable; however, some evaluators of business value will ascribe value to a business based on its assets, for instance patents or critical or special machinery. Since asset values are not usually the primary focus of most buyers and investors, the fair market value component is not heavily weighted.
In summary, why are finances so important? Quite simply, the number reason by far why buyers and investors own business interests is to make money and Finance measurements are how they determine whether it is good or bad.
The organization’s primary focus is to grow business value for clients through consulting services, training and education, and executive network groups. Our vision is to establish the region as an internationally recognized leader in manufacturing competitiveness. We believe growing business value improves the standard of living and quality of life for those that live and/or work in the region.
Please let DVIRC know if you wish to discuss these further. BETTER YET, schedule a complimentary Value Components Assessment of your business to discuss how you can improve the value of your most important asset.
About RLS Associates
RLS Associates is the Oldest and Largest M&A Firm headquartered in Delaware and has been representing Sellers and Buyers since 1986. They will be addressing questions/topics like:
- When is a Sale of a Business not a Sale?
- How to get your dream job by selling your business?
- What are your best exit options?
- How to maximize value, but keep the process confidential
- Why there are so many more buyers than sellers and what it means to owners and buyers
- Lessons Learned From The Dealmakers’ Deal — How they handled an internal acquisition from their own founder and what they learned/confirmed from it