A couple of posts ago I ran off at the mouth about valuations. I promised to say more about it. Valuations are really the most important thing a business buyer can learn early on. Not understanding valuations can handcuff you from making any kind of decision on going forward. If you don’t know how much a company is worth, then how can you make an offer for it? If you can’t make an offer for it, then what’s next? Right, go get a job. Now if you are like, me you look straight down your nose at the those who have jobs. We want to own the whole show and then sit back and collect money.
When comfortable in the acquisition space you should be able to do your own valuation in three minutes. That is what Warren Buffet does and so can anyone. OK, so let’s go back and figure out how much our company is worth. Now this is for the laziest of lazy people who just want the simplest solution possible. There are many factors that go into a valuation. But the thing that nobody needs is an appraisal. An appraisal might actually be remotely fair in assessing a market value for a company. Problem is it is done in a vacuum with no ability to take the business or industry pulse. You can accomplish the same thing as an appraisal by taking the current year earnings and multiplying by 5. Maybe 4 depending on the size and industry.
I am going to tell you to average the last two or three years of earnings and multiply by 3. Now it might be 1.5 – 2 if the owner’s salary is already added back to earnings (EBITDA should actually be used with all appropriate addbacks). And I will also tell you to throw out any “spike” years where the earnings are unusually high. You might say that sounds like a pretty low valuation. I say no. First of all that is the Buyer’s starting point and you will be compelled to raise your offer any number of times before a negotiation is complete.
On top of that Brokers and Sellers will always try to price their deal off the highest year. Often that is the current year. That happens a lot this year because 2007 was very good, much better than 2008. Asking price is always a ridiculous distortion. It is generally created out of a combination of greed, ignorance and wishful thinking. Asking price could be a quarter or a third higher than any appraisal would show. So your offer should be a third lower. That is, if an apparaisl showed $6 Million, then the seller might well ask 8 or 9 million. In reality, the offer should be around $4 Million maybe even $3 Million. Which is it? If in doubt, pick the lower of the two. Offering $3 Million for a company earning $1-$1.5 Million is not unusual.
As I sit here, here is a news flash to illustrate my point. I am looking at a company with $500k in earnings. The broker just informed me they want $4.0 Million all cash to close. That is 8 times earnings in an all cash deal. Companies 10 times this size might get that deal. I didn’t start this fishing expedition, they did. Two can play it that way. I rest my case.
So for example, the same $500,000 might bring an appraised value of $2-2.5 Million. But I’m going to offer $1.5 Million. All cash? No way. That is the next lesson.
