In the private business world, vendors often list businesses for sale as price plus stock. For example, you may see a business advertisement with the price listed as $Xm + SAV (stock at value). The vendor is assuming a separate value for the business (assets, goodwill, etc.) and a separate value for the stock (or inventory).

If this business is an insurance company and the stock refers to a few cows at home, then I can understand the separation. But, if the business is a computer retailer and the stock relates to computers for sale, then I disagree with the separation. (The business requires the stock to operate.) The price for any business should relate to the cash flows of the business. Without the stock, there is no business and there aren’t any cash flows. Ergo, the stock and the business are one, and the total price paid should reflect the value of the cash flows from the combination.

Let’s try an example. Say a vendor asks for 4x earnings plus stock. Earnings are $10m and stock is worth $30m. So that equals $40m + $30m, which equals $70m. To me, that’s 7x earnings, not 4x. The usual argument from the vendor is that if I ignore the value of stock and only pay $40m, then I could run the business for a year ($10m in earnings), sell all of the stock ($30m+) and I’d have all of my money back, hence, I am only paying 1x earnings. At first, that seems reasonable.

But, my assumption is that the business needs $30m in stock to operate properly (as a result of lead times, bad stock, warranty claims and forward orders). So, if I sold the $30m in stock, then I couldn’t operate the business properly and hence wouldn’t have a business with ongoing earnings of $10m anymore. What this inventory requirement really represents is a necessary investment in the business to maintain normal operations. It is an investment to produce the $10m earnings; it will not lead to extraneous earnings. Moreover, if there are plans to grow the business, the inventory requirement will increase and the business will require additional investment.

When I say I’ll pay 4x earnings for the ongoing cash flows of $10m, that $40m includes my total investment to produce those cash flows; it includes the initial purchase price, the adoption of any debt, working capital requirements (including inventory) and anything else that is deemed a liability (such as pension provisions). If, for example, pension provisions plus required inventory totals 4x earnings and I only want to pay 4x earnings, then it becomes investment gratis (purchase price zero).  (Sometimes a business is worth more liquidated than as a going concern.)

The question: does an investment with negative equity, but positive cash flows, mean positive or negative value for the investor? Using the earnings multiple valuation method, if net debt is greater than EV, then equity value is negative for the investor. However, it also seems intuitive that if FCF is positive (after interest payments are deducted), then the investment should have a positive value. So, which one is correct?

This is a similar issue that VCs have with investees that don’t have positive earnings (or only slightly positive earnings). If they use an earnings multiple to arrive at EV (and hence equity value), then often they will see negative equity value. But, there’s usually value in patents or technology or products or people or distribution channels or other IP. VCs deal with this concept on a daily basis, but private equiteers don’t (well, they do now), so it all seems quite foreign to them.

The simple solution is to use another valuation method, such as DCF, comparables, or revenue multiples. But, this seems like finding a solution to give a desired outcome. Maybe, these investees are really worth nothing. Maybe, the inherent risk in them has a greater cost than the PV of the cash flows. Maybe, these cash flows represent a return less than the required return to the investor. In all honesty, I’m not feeling the need to change valuation methods; if the numbers are poor enough to show negative equity but positive cash flows, then I think I’d leave it for another investor or another day.

In a previous post, I talked about the amplifying effect of diminishing sales. I gave a short example in which a company had sales of $100m. This company had variable costs of $40m and fixed costs of $40m; hence, EBITDA of $20m. A 20% loss equals sales now of $80m, variable costs of $32m (using the same gross margin), fixed costs of $40m (because they’re fixed), and EBITDA of $8m. In short, a 20% drop in sales led to a 60% drop in EBITDA.

I want to take this example a little further to show the amplifying effects of debt. So let’s use our two scenarios from above; Scenario 1 is the business with $100m sales and $20m EBITDA, while Scenario 2 represents some period later when sales drop to $80m and EBITDA is $8m. (Quick note: see how EBITDA margin dropped from 20% to 10%? That’s due to the fixed costs staying… fixed. And this isn’t an extreme case; it’s actually based on conservative numbers.)

Let’s assume the market is paying 5x EBITDA for this type of business. In Scenario 1, that means enterprise value (EV) is $100m, while in Scenario 2, enterprise value has fallen to $40m. When we made our investment into this business, we were quite conservative by employing debt of 3x EBITDA; so let’s assume net debt for the business is $60m. In Scenario 1, we invested $40m of equity with the $60m of debt to buy the business. But, now that sales have dropped, we’re worried about the value of our equity investment.

Well, you can probably see where this is going. With a drop in sales of 20%, which hypothetically led to a drop in EBITDA of 60%, we now have a business with an EV of $40m, with net debt of $60m, and hence, a negative equity value of $20m. That’s right, our investment is worth less than zero; it’s worth negative $20m. All of this, just from a 20% drop in sales. Quite a sobering thought.

This post follows on from these previous posts:

• What’s the deal with capex anyway?
  
• Free cash… flow, a primer
  
• The free cash flow capex conundrum
  

In all of my posts about FCF, I haven’t yet mentioned why investment bankers and private equiteers don’t use FCF in practice. Well, FCF is still too “bottom line” for business valuation. It includes taxes and, depending on what version you use (there’s FCF, FCFE & FCFF), it can still be swayed by capital structure. This is why good ol’ EBITDA still forms the basis of most valuations.

However, EBITDA isn’t the perfect measure either; it is still an accounting construct. The advantage of EBITDA over FCF/FCFE/FCFF is that it is independent of depreciation, cost of capital (such as interest on debt) and taxes. The disadvantage of EBITDA is that it doesn’t account for capex, which is a vital driver to ongoing earnings. The other difference compared to FCF, is that EBITDA still includes accrued debtors and creditors. However, for the purpose of business valuation, this is a better representation of the future (as long as there’s no fraudulent manipulation) because accrual accounting is forward looking.

The implication of the capex omission (from EBITDA) is that the EBITDA of one business doesn’t compare well to the EBITDA of another business; the reason being that each may have different capex profiles. In a previous post, I explained that we can’t just use historical capex to adjust FCF (or in this case EBITDA), because it usually contains one-off items. So, what many people do is use EBIT as their earnings proxy because it accounts for capex via depreciation (the argument being that depreciation is a good proxy for capex). Of course, this is fraught with danger because the past isn’t the future and the future isn’t the past. If anything, most businesses will spend more on capex than they depreciate as they grow and enter different industries.

Unfortunately, the solution isn’t so simple. In my opinion, the best earnings measure to use for business valuation is a maintainable and forward-looking EBITDA figure adjusted for the capex required to operate the business under normal conditions. Most of the work will probably go into understanding the real capex position of the business, but at least you can sleep well knowing you’ve invested on robust, rigorous and realistic analysis. So just to recap, the potential measure for earnings when calculating value includes:

• NPAT - almost never used, too “bottom line” and a pure accounting construct
• FCF - still too “bottom line”, capex is often backward looking, rarely used in valuation
• EBITDA - ignores capex, which is an absolute sin, but this measure is commonly used
• EBIT - ignores the evolving nature of capex, sometimes used, 2nd best of many bad options
• EBIT-DAC - can still be manipulated by accruals, but the best of a bad lot

For the record, in Europe, EBITDA minus capex is denoted as EBIT-DAC or EBITDAC.

It’s not exactly news that multiples are heading south. Data from Preqin and many other sources showed 2007/2008 purchase multiples being north of 8x, often with debt representing 5x. Now however, purchase multiples are more likely to be around 5x, with debt representing about 3x (if you’re lucky). This is a major issue for funds that made purchases at 8x, because they need to use regular value creation tools (heaven forbid), such as sales growth and cost cutting, to keep value from plummeting.

But, that’s another story for another day; I would rather talk about what drives valuation multiples. This can refer to multiples used in fund valuations, deal negotiations, or for whatever purpose. So, the following list describes the individual drivers for proposed purchase multiples of businesses:

• Business size: a larger business has a larger market share (usually), more stability (mostly) and is more attractive to buyers (generally). Therefore, a larger business demands a premium.
• Stability: revenue and earnings stability drives confidence in forecasts and more bankable forecasts demand a premium. Unstable businesses are riskier and require a higher required return, hence a lower multiple.
• Diversification: a business with a diversified product range, customer base and supplier list is less risky. These all affect earnings stability (see above) and hence, influence the multiple.
• Capex: this is often forgotten when just looking at EBITDA, which is why some people use multiples of EBIT (using depreciation as a proxy for capex) or good ol’ FCF (free cash flow, which accounts directly for capex). Capex represents a large portion of costs that don’t hit the P&L (until depreciated), so it’s important to consider capex in your valuation. Reduce EBITDA multiples for high capex businesses.
• Intellectual property: in private equity, we tend not to pay extra for IP because it is often needed to produce the cash flow. However, we may pay a higher multiple because proprietary IP represents greater differentiation, more stability, higher barriers to imitation and less risk.
• Growth: revenue growth is important to private equity because it’s one of the main tools to achieve value creation. So, a business with higher (and realistic) growth forecasts demands a higher multiple. However, it’s important to be pessimistic about management forecasts because 90% of the time they don’t eventuate.
• Synergies: a buyer that has the potential to realise synergistic benefits from an acquisition can generally pay a higher multiple because the acquisition represents a greater value to them. This is one of those drivers that mean the ideal multiple for me can be different to the one for you.
• Debt capacity: more debt adds more risk (insolvency, default, etc) to the business, but it also amplifies returns and reduces the overall cost of capital. The ability to add more debt commands a premium.
• Deal terms: a purchase multiple can be manipulated by the terms of the deal. If the deal is 100% cash up-front, the multiple will be lower than if some of the purchase price is contingent on future earnings. Be very cognisant of the time value of money and that contingent payments have less value if paid later. So, if $100m is paid today plus $100m is paid in 5 years, the purchase price isn’t $200m. It could be more like $130m, depending on your discount rate. A much higher multiple can be shown on paper through deal manipulation.
• Comps: although comparable transactions are the most common drivers of multiples, they are often the least appropriate. Even if exactly the same business sold at exactly the same time, synergies and other buyer-related drivers (deal terms, debt capacity, etc.) can affect the real value of the business. But in saying that, you’ll almost never see the same business for sale at the same time, so many other variables are introduced. So, it’s best to be more objective and concentrate on the more fundamental drivers that I’ve listed above.

As always, if you have anything else to add or disagree with my points, please leave a comment.

Following on from my previous post regarding investee valuations, I want to give a brief explanation of (and make a few comments on) the earnings multiple valuation method. As discussed, in the other post, this is the preferred valuation method for most situations. It represents what someone would pay if you tried to sell under normal conditions, which is arguably the most appropriate valuation method for private equity investments.

In the broad strokes, this method entails applying an industry-based multiple to the earnings of a business to arrive at an implied enterprise value. From this enterprise value, subtracting net debt gives the equity value. In simple scenarios (involving only ordinary equity), a private equity firm’s relevant investment value is equal to their proportional stake in the investee’s equity.

The subjectivity of this method comes in the following forms:

• Do you use last year’s actual earnings number? Do you use a forecast? If so, whose forecast do you use? And what earnings are we talking about: NPBT, NPAT, EBIT, EBITDA? What about the effect of non-recurring costs, contributions from discontinued business units, forecast acquisition synergies, etc?
• What is an appropriate multiple? Are transactions from six months ago reasonable comparisons? Should I only use transactions from the same industry as comparables? What about company size: should I only compare those of similar size? What if there haven’t been any transactions for 12 months (this is especially applicable now)? Should I use the mean, mode or median of comparable transactions?

There are a lot of questions there and not many answers; it really depends on how honest you want to be with yourself and the limited partners. Here are my suggestions:

• Earnings - You should use the earnings number that you expect at the time of reporting. For example, this may be the current year’s EBIT forecast adjusted for the latest actual earnings figures (that is, if you were below budget, adjust the forecast months accordingly). If the trend is towards using the previous year’s earnings, then you should follow suit.
• Multiple - In the current climate, you may need to look outside your industry for trends, but also make sure to look for similar sized transactions. There’s no perfect multiple to use, but there’s certainly a range that will seem reasonable. I’d say in the current environment that anything over 8-10x would be unreasonable. For mid-market deals, I wouldn’t expect to see multiples over 6-7x, unless there is a strong case for exceptional growth. It may surprise you, but I’m seeing some interesting deals go for 3x now.  

You’ll know in your own mind whether you’re being fair with your analysis. Try not to cheat yourself because there’s a real danger that it could come back to haunt you. There’s always the argument that if things really do get better, investors will be glad to see a significant uptick in your next report. If you’re too optimistic now, disappointing them twice will hardly be fun. Also, investors won’t be surprised with value losses now; they’re probably expecting them. So take this opportunity to take an honest look at your portfolio and move on to planning for the upturn (now there’s some positive thinking).

I had a surreal experience at the end of 2008 trying to make sense of investee valuations. While I sat, staring at the snow in anticipation of some profound thought, I realised that all of the noise and clamour of the “financial crisis” had disappeared. It was as if some deity had used a constant and unrelenting snowfall to hypnotise the globe into a cryogenic slumber to give it time to reconsider itself and its actions.

Anyway, after rejoining reality, I wondered what the softening economy and 30-40% falls in public equity markets meant for my firm’s investees. Since times had significantly changed, I had to revisit the EVCA valuation guidelines to understand how I would be valuing these businesses. In doing this, I thought it would make a worthwhile post to give a very brief overview of the recommendations.

The EVCA uses the same guidelines that many other national private equity associations use, and as such, they recommend the following valuation methods (http://www.privateequityvaluation.com):

• Price of a recent investment method – used within 12 months of an investment if there haven’t been any material changes (I think we’d all agree that expectations have materially changed).
• Earnings multiple method – using the latest earnings forecast and an appropriate and reasonable multiple for the applicable industry and size of business, with a marketability discount applied. 
• Net Assets method - only used in cases where the underlying asset is traditionally valued according to specialised methods; such as property or a portfolio of listed investments.
• Discounted cash flows method – used in many other circles, but apparently based on too many subjective assumptions to be useful to the time horizon of private equity.

Upon reading the guidelines, you quickly notice support for the concept that something is worth only what someone is willing to pay. I say this because there is a heavy bias towards the earnings multiple method. This is okay with me, but I feel I should make a post in the next few days on the implications of using this valuation method. So stay tuned… and don’t spend too much time staring out into the snow.

For businesses considering their options for accelerated growth, they tend to gravitate towards proposals that contain a financial and strategic component. With this in mind, the most compelling expansion deals are usually from trade investors and private equity firms. In this post, I’m going to compare these offerings in a formulaic manner.

So let’s assume:

• $X = The value of financial capital in a deal
• $aX = The value of strategic support in a deal

The value of strategic support is a multiple of financial capital because the whole purpose of the investment is to multiply the initial investment. Note: the “a” only represents the strategic value-add, not the realised cash multiple for the investor because there are other influences that drive the final result.

Therefore, the value of a financial+strategic deal ($Y) is:

• $Y = $X + $aX

When a business faces making a decision between a trade deal (JV, strategic investment, etc) and a private equity deal, they’re often deciding between the following two scenarios:

• Trade Deal:    $Y = $X + $aX
• PE Deal:          $Z = ($X - some) + ($aX + some)

In simpler terms, a trade buyer will usually offer a higher upfront valuation, while a private equity firm will offer greater strategic value. My thinking for this is that a trade buyer has greater immediate synergies and is often the more natural buyer of the business; hence, it may pay more. Whereas, a private equity firm has more experience in value creation AND it has more aligned interests; hence, it offers greater strategic value. I say more aligned interests because there’s the risk that the trade buyer wants to invest in the business as a defensive move and they actually don’t want the business to grow. This is a significant risk compared to a private equity investor who almost undoubtedly just wants to see growth.

With all of that said (and this is hardly an exact science), the question for the business owner is whether the additional upfront value from a trade buyer is worth more than the additional strategic value offered by the private equity firm. This is where the deal becomes self-selecting. If the business owner sincerely believes in the potential growth of the business, then they’d really choose the deal with the higher strategic value: the private equity deal.

Best regards,

the Private Equiteer