Economic Value 101
By AICC Staff
June 4, 2019
In the last issue of BoxScore, I suggested that the best way to measure success is through the lens of returns on and changes in economic value (EV). The key question that a prudent businessperson should always be asking is, “How can I increase the long-term value in my/our business?” In my opinion, every major decision that is made should be looked at in terms of the effect on value, whether there is any thought to selling the business and “liquifying” this value. Now, you might say that without putting the company up for sale, there is no way to really know what it is worth. The purpose of this exercise is to get you to focus on the things that should increase EV and to create action plans to implement improvements in these areas, not on calculating a precise value. The key is to be consistent and conservative in your methodology. Don’t pick the highest possible multiples, and don’t be afraid to let serious identified deficiencies in your operation reduce values accordingly.
For instance, if your plant is too small and poorly laid out, if your equipment is old and obsolete, if your management team is thin, or if your workforce is getting older, you can factor these things into your EV model and get a better sense of the overall health of your business. Believe me when I say that when you do decide to go to market with your business, the potential buyers will be making a similar evaluation. At the end of the day, a buyer is always concerned with the overall risk of the transaction and with areas where they will have to make additional investments and devote resources to the deficiencies they inherit. Increases in risk will generally lower the overall “multiple” that they are willing to apply, and future investments will reduce the dollar amount that they will be willing to spend.
You also may have hidden increases and decreases in value on your balance sheet relating to the accounting conventions used in the creation of financial statements under U.S. generally accepted accounting principles (GAAP). In the United States, all capital assets are reported at historical cost less depreciation, which means that assets such as real property that was purchased many years ago will be shown on the balance sheet at values that are significantly lower than they are currently worth. It also means that the value of recently purchased assets may be overstated. In addition, you may have intangible assets on your balance sheet that have little or no real worth, so a balance sheet review is also a part of this process.
The following is a list of external factors that will affect the value of your business:
- Overall business conditions: How do interested buyers feel about the economy short-term and long-term. Is this a good time to take on risk?
- Regional business conditions: Are you in a region that is growing or shrinking with respect to customers who purchase packaging?
- Your location relative to suppliers, customers, and competitors: What resources do potential acquirers already have in place in your region, and what changes are being planned? What initiatives are being planned by competitors and suppliers in your region?
- Global containerboard markets: Integration value varies greatly depending on this.
- Overall cost of debt and equity capital: When the cost of capital is perceived to be at historically low levels, it is much easier to get deals done.
- Competitor and customer current and future planned activity in your area.
The following is a list of common internal factors that will affect the value of your business:
- Customer concentrations: This is possibly the biggest risk to an acquirer. If the loss of a few customers represents a disproportionate amount of your sales, the risk of failure and, ultimately, the multiple paid will be lower.
- Heavy reliance on broker and trade business: An acquirer will likely reduce the multiple if you are selling a lot of trade and broker accounts because the risk of not being able to retain this type of business is far greater than it will be with sales to end users.
- Key customer management concentrations: It seems that no one has any extra managers to move into a target, so having a thin management team is a big negative.
- Ineffective management team: A poor management team usually means a poor culture, which is very hard to overcome. A lot of small businesses make this mistake—too many key management responsibilities and too much customer relationship management lie with the owners. Most acquirers find that it’s hard to keep former owners motivated after a transaction. A professionally run company with in-place management is worth much more than one dominated by former owners and their family members.
- Aging workforce: Finding good long-term employees is possibly the biggest issue facing small business today.
- Tons of paper consumed by the operations: Recent history has shown that paper cut up or MSF consumed (integration value) can be a significant factor in the value of a converter, and the larger the operation, the more this becomes a factor.
- Old, inefficient equipment: If a buyer must spend millions of dollars upgrading your equipment, theyvwill pay you less (probably dollarvfor dollar).
- Poor plant and/or poor plant layout: Ditto.
- Flawed and incorrect financial and other management reporting and bad business practices: If they don’t trust the information they receive from you, they will consider the transaction riskier and pay less.
- Pending or threatened litigation: A buyer will want to be insulated from this, so any hit that is taken will likely be borne by the current owners.
- Poor reputation: It’s very hard to overcome this one.
- State and local sales and income tax : Buyers will evaluate your compliance with laws to make sure they are insulated from any tax claims. It is important that you make sure that you are filing income tax returns, sales and use tax returns, etc., in all jurisdictions in which you operate.
With all of this theory out of the way, let’s talk about how you can create a usable model for calculating the EV of your business to aid you in the evaluation of how your business is performing and what the effect of various initiatives is on the long-term value of your business.
Most buyers will look at earnings before interest taxes depreciation and amortization (EBITDA) generated for the past couple of years for two reasons:
- It is a bottom-line calculation of the cash flow that you generated that a buyer can utilize to pay for the business without any tax structure or financing assumptions.
- The results of the recent past are often the best predictors of future performance.
The EBITDA will then be normalized for things like the loss or gain of major customers and nonrecurring items of income and expense in the income statement. So, some notion aof normalized historical EBITDA should be the starting point of your calculation.
Next, an evaluation of all the aforementioned factors relating to risk will be evaluated and reflected in a multiple to be applied to the normalized EBITDA. So, to keep things simple and work with actual and implied multiples that can be extrapolated from recent M&A transactions, let’s say that the perfect company would be assigned a multiple of 10. You can then adjust the multiple that your company may receive by evaluating these key factors. You can then reduce this value by the perceived additional investments that a buyer would have to make and by the interest-bearing debt that you currently show on your balance sheet, and increase it by any hidden value that you may have, such as undervalued real estate on your balance sheet. Very few companies will sell for multiples of 10 unless there is significant integration value associated with the transaction, and therefore, you should be liberal in your reductions to the starting multiple based upon your company’s known weaknesses. Most companies without significant volume—and therefore integration value—will ultimately sell for multiples much lower than 10 in today’s marketplace.
Therefore, an average (or weighted average) of the normalized EBITDA that you have generated for the past few years, multiplied by a multiple that is adjusted by the relative risk factors associated with buying your business, less a possible provision for large future capital costs and less interest-bearing debt plus the value of any hidden assets would equal your enterprise value. Make these evaluations and calculations at least annually to enhance your overall reporting and business analytics.
The beauty of this exercise is that it can and should tie into—or possibly facilitate—your strategic planning, in that it will get you to focus on the things that will ultimately make your company more profitable and increase its EV. It will also give you a consistent lens through which to evaluate returns on investments, equity, and assets, and hopefully, it will give you a more realistic view on your progress—or lack thereof.
Mitch Klingher is a partner at Klingher Nadler LLP. He can be reached at 201-731-3025 or firstname.lastname@example.org.