Valuing a business is rarely cut and dried. It is usually a complex process driven in large part by a subjective read of company characteristics alongside objective market metrics, and valuations are dynamic, shifting with market conditions, the trajectory of results, changes in customers and vendors, and the competitive environment. Beyond the usual factors, certain characteristics make a company especially hard for the market to value.
Quality of earnings is rising or falling sharply
The challenge is determining the new sustainable plateau. If EBITDA has climbed from $1 million to $5 million over four years, will it keep rising by $1 million a year, or is $5 million the new normal, or is the sustainable level somewhere in between? Determining the base requires understanding what drove the gains and whether those factors will last. The same is true on the way down: where is the bottom, and how would you know?
The business depends on commodities or is cyclical
Commodity prices are volatile, so earnings move with them. It helps to review unit sales irrespective of price, then normalize earnings to baseline commodity prices to find the trend. For cyclical businesses, you need the average earnings across a full cycle, which raises hard questions: how long is a cycle, how many cycles to study, and what is a sustainable level of profitability? In a down cycle the company can look overvalued by this method, and in an up cycle, undervalued.
It is subject to regulation that changes over time
As administrations and policies change, so do the laws that govern an industry. Skilled nursing is a good example, heavily dependent on reimbursement rates that the government raises and then claws back. When rates rise, valuations rise, but the increase may not be sustainable, which makes these businesses hard to value.
Earnings growth depends on periodic innovation
The key question is whether the company will keep inventing products the market wants. Apple is the classic example, dependent on a continuous pipeline of new and improved products and on customers wanting them. There is no guarantee innovation continues or demand persists. It also matters whether the ability to innovate rests with the owner or a few people, or has been institutionalized.
Consumer tastes and trends drive earnings
Tastes are fickle and ever-changing, so it is hard to value a business whose earnings depend on correctly reading consumer taste again and again. As with innovation, the question is whether that ability is institutionalized or sits with the owner and a handful of people.
Most profits are earned in one calendar period
Many retail businesses make most of their money during the holiday season. Predicting full-year results is difficult when the company manages lean months in anticipation of the period that makes or breaks the year. Call it the seasonality factor.
High book value but declining earnings
When earnings and cash flow are falling but the company is still profitable with a strong book value, an earnings-based valuation is hard because you cannot tell if or when results will bottom out. A valuation based on adjusted book value, perhaps with a slight discount for the inadequate return, can be one workable approach.
Owner add-backs that are hard to verify
Owner expenses are a notoriously difficult line item, often a mix of commingled travel, entertainment, and other costs that cannot be objectively confirmed. Consider an owner who hosts client events, buys gifts and door prizes, and picks up a few pricey items for themselves along the way. Some of that is a real cost of entertaining and some is not, and it would disappear in a sale. The question is how defensible and documentable those add-backs really are.
The company relies on high-ticket-value sales
Like commodity-based or cyclical businesses, a company that sells high-priced items such as heavy capital equipment is hard to value, because demand and cash flow swing year to year and customers turn over significantly. Projecting future results with any certainty is difficult without understanding the customers' appetite for those products.
There are unmeasurable assets and liabilities
In a knowledge economy, a company's most valuable assets, patents, management experience, research and development, or highly specific processes and systems, are often intangible. They have no natural home on the balance sheet and are difficult, sometimes impossible, to measure directly. Ultimately those assets must produce consistent earnings and cash flow to be reflected, indirectly, in the company's value.
Difficult-to-value companies make it harder to set valuation parameters and expectations, but there are methods to work through the difficulty. Often the conclusion implies a structured transaction: over time, as the agreed earnings and cash flow hurdles are met, the owner receives the full valuation, and the buyer is comfortable paying it because the company delivered.
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