Written By: Andrew Gelfand
Read By: Christopher McKenna
Valuing a business is rarely a cut and dried process. In fact, it is typically a complex process that is driven in large part by the subjective evaluation of company characteristics in addition to objective market metrics. In addition, company valuations are dynamic based on a variety of factors including current market conditions, the trajectory of operating results, changes in customers and vendors, the competitive environment, etc.
However, beyond the usual suspects, there are certain characteristics that make it particularly challenging for the market to value these companies. Some of these characteristics are beyond the owner’s control and are at the whim of the market, while other characteristics are more company-centric.
Characteristic #1: Quality of earnings (QoE) is going straight up or straight down: The challenge here is determining the new sustainable level or the “new plateau” of earnings and cash flow. For example, if a company’s earnings before interest, tax, depreciation and amortization (EBITDA) has increased annually from $1 million to $2 million to $3 million to $4 million to $5 million, it is difficult to determine the new plateau. Will EBITDA continue to increase by $1 million per year indefinitely? Is $5 million the new plateau with market rate increases thereafter? Is the sustainable level somewhere between $1 million and $5 million? Determining the base level of EBITDA requires a thorough understanding of the factors that have led to the gains over the last four years and the sustainability of those factors. The same holds true for QoE that is going straight down — the question then becomes: where is the bottom and how do you know?
Characteristic #2: The company’s business is dependent on commodities or is cyclical: Commodity prices fluctuate, and they can be volatile, so the earnings of businesses that are dependent on commodities can be impacted positively or negatively depending on the direction of commodity prices. In this case, it is necessary to review unit sales to evaluate the overall trend of the business irrespective of commodity prices. It is then helpful to estimate baseline (or average) commodity prices in order to normalize the earnings, up or down, to determine the trend and the sustainability of QoE based on average commodity prices.
With cyclical businesses, it is necessary to understand the average earnings of the company over the entire length of the cycle. In this case, the following determinations need to be made: What is the proper length of a cycle – 3 years, 5 years, etc.? How far back, i.e., how many cycles need to be identified, to determine that? Given its cyclical nature, what is a sustainable level of profitability for the business? These are not easy questions to answer. In a down cycle, the company may appear to be overvalued by using this approach; conversely, in an up cycle, the company may appear to be undervalued using this approach.
Characteristic #3: The company is subject to regulation that can change from time-to-time: As administrations and policies change, so too do the laws that govern certain businesses and the industries in which they operate. A good example is the skilled nursing industry which is heavily dependent on reimbursement rates. At times, the government will increase reimbursement rates, then the tide will turn and they will decrease or claw back reimbursement rates. When reimbursement rates increase, valuations increase. However, given the inevitable regulatory shifts, these increases in reimbursement rates may or may not be sustainable. Therefore, it is a challenge to value businesses where profits ebb and flow depending on the prevailing regulatory environment.
Characteristic #4: The business is dependent on periodic innovation for a consistent increase in earnings and cash flow: In valuing companies of this type, the key question is: How is it possible to determine if a business will continue to innovate and invent new products that will be in demand by the market? Apple is a good example of a company that is dependent on continuous introduction of new product lines and the improvement of their existing product lines — the iPhone, iPad, iWatch, and its computers — and the desire of early adopters to purchase them. However, there are no guarantees that innovation will continue indefinitely, nor that market demand will persist, which can throw a wrench in the valuation process. In addition, is the ability to innovate dependent on the owner/a small number of employees, or has it been institutionalized?
Characteristic #5: Consumer tastes/fashion trends dictate the company’s ability to generate earnings and cash flow: Trends come and go, and consumer tastes are fickle and ever-changing. As such, it can be difficult to accurately value a business in which earnings and cash flow are largely dependent on the whims and wants of its customers and the ability of company personnel to correctly judge consumer taste on a continuous basis. In addition, as with innovation, is the ability to determine consumer taste dependent on the owner/a small number of employees or has it been institutionalized?
So, what is an owner of a difficult-to-value company to do? In these scenarios, the valuation conclusion can indicate the total value of the company that the owner may receive in a “structured transaction” over time, but would not necessarily indicate the cash price to be paid at closing. In other words, there is a base level of value that would be paid at closing with a contingent portion of the valuation including an earn-out and/or other contingent payouts based on achieving certain metrics in the future.
In Part Two of this series, we will review five more characteristics of difficult-to-value companies, so stay tuned.