I had a conversation with an SBDC consultant recently, about transaction databases and how to best utilize an analysis of that data when valuing a business. She suggested I share this information with her colleagues in the America’s SBDC network, so here it is.
There are several different databases, each maintained by different organizations, that track transactions of privately held businesses — the prices they sold for as well as various other financial metrics for each transaction. The idea behind these databases is that one could analyze transactions of similar businesses that have sold, in order to identify an indication of value for a business. But there is more to it than simply pulling up the data for the applicable SIC or NAICS code and calculating the average or median of the data provided.
The following is based on a couple of assumptions. First, that the data obtained from one of the databases consists of a sufficient number of datapoints to allow a detailed analysis, and second, that the purpose of the analysis is to determine fair market value (FMV). There are several other standards of value besides FMV, and those assignments may involve different analyses.
One of the first things I do, when asked to determine the value of a client’s business, is to compare the subject company’s financial ratios to its industry averages. I want to see how the business compares to its industry. If the company’s operations are weaker than the industry average, then a downward adjustment to an average transaction multiple may be in order. The reverse is also true. It doesn’t seem to happen very often, but if a company’s financial ratios fall in line with the industry average, then I have that support when I select an average multiple for use.
When analyzing a set of transactions, I also try to limit the deals I consider to a size-range similar to that of the subject business. It does not make much sense to look at sales of businesses that had $3-5 million in revenues when my subject barely cleared $300,000 last year. Again, the opposite is also true. If the business I am analyzing cleared $3 million last year, I am not going to include the transactions of those smaller businesses. The idea here is that larger businesses tend to be considered less risky as an investment, and therefore sell for larger multiples.
Some of the transactions listed in these databases list a publicly traded company as the buyer. I remove those transactions from my analysis, as a publicly traded company tends to accept a different return on investment than an individual would require.
Oftentimes there may be transactions that were organized as stock sales rather than asset sales in the database. Since I am not always sure about what assets were included in a stock transaction, I remove those from my analysis as well. Some stock transactions may have included cash, accounts receivable, and/or some other asset that may or may not have been an operating asset. Removing stock sales from the analysis clears up potential issues that may cloud a selected multiple. Also, depending on what database you are looking at, inventory may or may not be included in the calculation of the multiple reported for each individual transaction.
These databases contain transactions from all across the country, and sometimes from countries outside the United States. Some business appraisers believe that in order to have an analysis of comparable transactions, one has to remove all the transactions that occurred outside of the geographic location of the subject business.
I have a different opinion. For example, if I am analyzing a business that cleans carpets and upholstery and it is located in, say, the Chicagoland area, is it reasonable to assume that the operations of another business that cleans flooring in the Denver, Colorado area are similar? Is it likely that the two businesses both market their services to individuals and enterprises that have flooring to clean? Do their customer bases consist of some clients who pay their bills on time while others tend to lag over 30 days? How likely is it that each of the two businesses occasionally have problems scheduling their service techs to cover all their scheduled jobs?
If the operations of a business are likely to be similar across different geographical markets, then I believe the transactions were negotiated and consummated based on similar analyses from the individual buyers, and, therefore their multiples (the relationship between the price paid for the business and that business’ financial metric) are applicable for use in the analysis of my subject as well.
The age of the transactions is another issue to consider. Some analysts believe that any transaction over 10 years old is too old and should be discarded as a matter of course. Once again, I disagree. I will, however, test my data to see if the age of the transactions included in the database had any impact. The easiest way I have found to do this is to plot each transaction on a scatter graph and see what the trendline shows me. If the relationship between the price paid and the financial metric I am using has remained stable over the past 20 or 30 years, then I see no problem including the older data in my analysis.
If the trendline shows a marked decline over the same time period, I will still include the older transactions in my analysis, but this time as an aid to illustrate the decline over time. I will try and see if there is a reason for the decline, such as a change in technology, or demand for certain types of services — as in the case of video rental stores or one-hour photo development businesses. The idea here is not to make decisions based on some blind metric, but to consider each decision as one sorts the data to find applicable, comparable transactions to analyze.
Another item to consider is the multiples themselves. Two of the most commonly used multiples are the price to revenues and the price to seller’s discretionary earnings (SDE) multiples. Sometimes, one or the other may be more appropriate or may provide additional clues as to the details of each individual transaction. Some business brokers will submit data that includes the sale of real estate. Some of these transactions may not split out that portion of the sales price that belonged to the real estate and the portion that went to the business.
It depends on the industry, but for transactions of businesses that have significant costs of goods sold, a price to gross revenues multiple of more than one may include real property. Should those transactions be included in your analysis? Consider those businesses with very small price to SDE multiples. Were those businesses really not worth very much, or may the seller have been extremely motivated? Should those transactions be included in your analysis?
Once you have decided on the datapoints to include, calculate the median and/or average multiples, then consider your financial ratio analysis and decide if the subject company is stronger or weaker than the industry average. Then determine how much stronger or weaker it is and apply that determination to the selected multiple. It is rare that I decide the most appropriate multiple for use is either the average or the median multiple, but it does happen. Remember, it is also appropriate to determine a range of values if you desire. Valuation is both an art and a science.
If you would like to learn more about using the various transaction databases to determine an indication of the value of a business, or you would like to pursue your own Business Certified Appraiser (BCA) certification, please contact me at shyde@intlBCA.com. The International Society of Business Appraisers (ISBA) can teach you what you need to know to get started.