After valuing over 200 companies and selling about 50, I’m still asked by potential clients if I have ever valued a company in their industry. The underlying assumption is that there is “something highly proprietary about their sector”. Granted, there are nuances to every business sector that are useful to understand when determining an appropriate value for a given company, but it is really much simpler than most valuation professionals would lead you to believe.
In truth, to a business appraiser or a corporate acquirer, every company — no matter what products you produce, services you
provide or markets you serve – is in the same business: generating cash. The value of your business is simply the amount that someone would exchange today for the right to collect all the cash available to the owners of the business in the future. And since the future is uncertain, there are certain qualities for which investors are willing to pay a premium – qualities that I refer to as “value drivers.”
Let’s start with an elementary example. Assume you won the state lottery and were entitled to receive $1 million for 20 years. Would it be possible to find someone who would give you a large sum of money today in exchange for the right to receive those future payments? Of course. And what amount would they pay you today? Well, it depends, but it certainly would be less than $20 million. The exact same thing is true for a company and the answer is derived using the exact same principles.
The amount a rational financial person would pay for a stream of future cash flows depends on four factors:
- Returns available on alternate investments
- Predictability of the cash flows
- Sustainability of the cash flows
- Growth of the cash flows
Most valuation discussions focus on a multiple of some performance measure. For private companies, it is usually a multiple of EBITDA (earnings before interest, taxes, depreciation and amortization). For public companies, it is typically the price/earnings ratio. The reality is both of these multiples are actually derivatives of computing the present value of future cash flows. Consequently, whether a company is worth a high or low multiple is a function of the value drivers that dictate whether expected future cash flows will be heavily discounted or lightly discounted.
Since you can’t control the first item on the list – the returns that are available on alternative investments – I’ll instead focus on the value drivers that can be controlled. The first value driver is how predictable is the company’s cash flow? Historically, if your company has had up-and-down years caused by market cycles, management changes, loss of major contracts or other factors, your performance is not as predictable as others. A rational investor likes to know what to expect year to year and is willing to pay more for a predictable stream of cash flows (like a lottery ticket) than an unpredictable stream. As a result, rational investors will discount the value of future cash flows more heavily if they do not have confidence in their consistency. In other words, they are willing to pay a higher multiple of cash flow for predictability:
Similarly, at least to the extent that present cash flows are sustainable for an indefinite period of time, a rational investor will pay more for them. In the case of a lottery ticket, the soundness of the entity that stands behind the future payments has a major impact on the discount you would apply to future annual payments. If the state government is on the hook, you would feel very secure about receiving that 20th payment because states generally do not go bankrupt. But if a lottery ticket is an obligation of the corner convenience store, you would apply a much heavier discount when computing the expected value of distant payments.
There are many reasons an investor might not feel a company’s cash flows are sustainable indefinitely. One obvious reason is the market you serve. Is it declining? Is it growing? Is it transient?
Let’s assume Company A makes a product for which it owns the patent. Company B distributes that product under a contract that can be cancelled with 12 months notice. Both companies generate $1 million in cash flow per year. Which company is worth more? The answer lies in which one is a more sustainable business. The producer with intellectual property might sell at an EBITDA multiple of 8, while the distributor sells for a 4 multiple. Consider one company that produces trendy apparel for teenagers and another that provides basic services to the elderly. Which one has the more sustainable cash flow given today’s demographics?
Now assume that there are two pharmaceutical companies. One of these companies has a blockbuster drug, but only one product, while the other company produces 20 different medications, but derives no more than 10 percent of its revenues from a single product. All else being equal; which company; deserves the higher multiple? Clearly, the one with the broader product mix has more sustainable cash flows because a single new drug cannot cripple its business.
Recently, I valued a government contractor that secures most of its contracts as small business set-asides. Since a large company would not qualify to bid on many of the contracts, my client’s business is not fully sustainable in the event it were ever acquired. Therefore, we had to apply low multiples in determining its value.
With regard to private companies, an area where the sustainability of cash flows often comes into play is the depth and breadth of the management team. Many private companies are truly a one-man or one-woman show. The loss of a single individual would have a profound impact on the ability of the company to continue to perform as it has in the past because that one person may be the primary rain maker, product designer or the glue that holds the family business together. When a private equity fund looks at investing in a private company, it will knock a minimum of one or two points off the EBITDA multiple it is willing to pay if there is not a strong management team and at least one person who could readily step into the shoes of the owner/CEO.
A company’s growth rate is an obvious key to valuing future cash flows as well. Not surprisingly higher growth rates result in higher values. The lottery ticket may have a predictable payout, and it may be sustainable for 20 years, but there is no chance of the payout growing.
Consequently, it is possible that a business with an annual cash flow much less than $l million today could be worth more than the lottery ticket even though its future cash flows are less predictable. The company may continue to prosper well beyond 20 years, thus be more sustainable, and its cash flows may grow nicely for the foreseeable future, far outpacing the lottery payout in later years.
So the next time you ponder why some firms sell for four times EBITDA and others sell for 10 times EBITDA, you can rest assured that the reason lies in one or more of the above value drivers, each of which dictates a rational investor’s perception of the present value of expected future cash flows. And if you want your business to become a company that sells for a higher multiple, you need to find ways to make your cash flows more predictable and more sustainable, as well as to grow more rapidly.
About the Author: Michael Jacobs is president of Jacobs Capital, an M&A and business valuation advisory firm based in Atlanta. He served as director of corporate finance policy at the U.S. Treasury Department from 1989 tom 1991, and is the author of Short-Term America and Beat the Wall Street Rule. He can be reached at email@example.com.