Wednesday, August 31, 2016

The Importance of Adjusting Value for Capital Structure

One of the most common errors made in small company business valuation reports in the Income Approach is failing properly adjust for capital structure.  In the following case, accounting for working capital and capital structure result in huge value adjustments.

HMR Manufacturing, Inc.

You’re a newly hired valuation expert working for a private equity firm.  The partner you’re working with needs a valuation of the stock of HMR Manufacturing, Inc.  Your firm is considering a controlling position in HMR’s stock.

HMR is a world leader in the design and manufacture of hydraulic power units for marine applications.  The company was founded by the current owner’s grandfather over 40 years ago, and has been highly profitable for most of that time.  The owner and CEO, Hank, is asking $6 million in cash for 100% of the stock.   The firm needs to know if they can pay Hank his $6 million and still achieve their required ROE of 28%.

Some facts about HMR:

Annual Revenue:                   $10,000,000
Normalized Cash Flows:       $1,000,000

Cash/Checking:                     $800,000
Accounts Receivable:            $1,600,000
Inventory:                              $500,000
Fixed Assets:                          $500,000
Real Estate:                            $1,500,000
Total Assets:                           $4,900,000

Accounts Payable:                 $300,000
Long Term Debt:                   $0
Total Liabilities:                     $300,000

Long Term Growth Rate:      2.0%
Tax Status:                             S Corporation (no corporate tax rate applied)

*All values are fair market value.

Given that the company has no projections of near term income volatility, and that their long term expected growth rate is near the inflation rate, your boss tells you to value the company with a Single Period Capitalization Method.

E = 1,000,000 / (.28 - .02) = $3,846,156.

Based on this valuation, you tell your boss that the firm cannot buy HMR for $6 million and achieve its required ROE of 28%. After making a crack about your lack of grey hair, your boss declares: “You’re wrong.  We’re buying a controlling interest!  We’re not stuck with his lousy capital structure.  Look at this:”

  • RMA data shows that the average manufacturing company of this sales level has only 50% of it’s total assets invested in current assets, and we intend to beat that average.  We’ll distribute the cash, and manage the receivables and inventory until the total current assets are less than $2,000,000; that’s $900,000 we add to the valuation because we can take it back and reduce our initial investment.
  • RMA data also shows that the average manufacturing company at this sales level has current liabilities equal to 30% of total assets.  Assuming total assets of $4,000,000 (after reducing current assets), we should be able to carry payables of $1,200,000; another $900,000 of free capital that can be added to the valuation.  Effectively, HMR currently has net working capital of $2,600,000 where industry data suggests only $800,000 is necessary.   HMR has excess assets (unnecessary for producing the normalized cash flows) of $1,800,000!
  • We can easily borrow against HMR’s fixed assets at 50%, and real estate at 70%, for a total long-term debt structure of $1,300,000.  Our expected long-term interest rate is 6%.  That’s another piece we can remove from our equity investment (Weighted Average Cost of Capital, or WACC).

Re-running the income approach valuation for these adjustments gives us:

E = (((1,000,000 – (1,300,000 x .06)) / (.28 - .02)) + 1,800,000 + 1,300,000

E = ((1,000,000 – 78,000) / .26) + 3,100,000

E = 3,546,154 + 3,100,000

E = 6,646,154

The private equity firm can pay as much as $6.6 million for HMR’s stock and still achieve it’s ROE of 28%.  After pulling $3.1 million out of HMR’s reorganized capital structure it will only have invested a net $3.5 million of equity.

(Note: If HMR had any long-term debt, the $1,300,000 debt adjustment would have been reduced by that amount.)

Aren’t the planned changes in company capital structure synergistic, and therefore not to be considered on a fair market value basis?  No.  The anticipated changes in working capital and debt structure are based entirely on the company’s existing resources (not the private equity firms credit, etc.).  Further, optimizing the company’s capital structure to maximize shareholder value is no different than making normalization adjustments to cash flows resulting from a controlling ownership interest. 

For example, reducing the owner/CEO’s salary to a reasonable level is what we would expect a purely financial investor to do upon taking a controlling interest.  Optimizing capital structure is no different, and is evidenced in the market place.  Any other private equity firm considering acquiring HMR would make the same considerations when determining their maximum bid price.  Optimizing capital structure is always a consideration by market participants, and therefore must always be a consideration in determining the value of a controlling equity interest.

Brian Murray CPA/ABV, CVA
Murray & Roberts CPA Firm SC

Sunday, August 17, 2014

Business Valuation Multiples

Earnings multiples and so called rules of thumb have been around as long or longer than the practice of business valuation itself.  One of the key approaches to estimating the value of a business is the Income Approach, which is based on the present value of future expected earnings.  That sounds very similar to a multiple of earnings, doesn't it?  It may, but it isn't.

Using a multiple of earnings may not be a bad way to put the value of a business into a very large ball park, but that's where the thumb ruler should stop. Promising to buy any company for four times earnings - because you heard that was the going rate - makes as much sense as promising to buy any real estate for $100,000 per acre for the same reason.  Yes, every piece of real estate is unique, and so is every company.  Therefore, your source of earnings is also unique.  Paying a set amount for a every company's earnings means the investor is requiring the same rate of return on each company.

Paying a set multiple for earnings fails to account for growing earnings, declining earnings, volatility of earnings, the risk or lack of risk attached to the specific business and its earnings, and last but not least the degree to which the assets being acquired can be collateralized.  All of these things can dramatically change the rate of return realized to an investor on companies with the same earnings at the start.

Which earnings?  EBITDA is the usual favorite to which multiples are applied.  But EBITDA can also be deceiving, particularly in a business that is capital intensive, because it fails to account for the reduction in cash flows resulting from necessary reinvestment into equipment.  

When it's time to make or accept an offer, a difference of 4, 5, or 6 times earnings can mean millions.  A thorough valuation of the company can expose its real drivers of value.  That's a small investment that can save a buyer or seller from making a million dollar mistake!

Brian Murray CPA/ABV, CVA specializes in business valuations and merger and acquisition consulting, and has served as an expert witness in court.  Please call Murray & Roberts CPA Firm SC at (920) 225-6436 to find out more or visit our website, and click on the BUSINESS VALUATION link.  Go to now for a fast and affordable business valuation report prepared by Brian Murray.

Friday, August 8, 2014

Real Estate in Business Valuation and Company Value

Why is it important to factor out real estate when valuing a business?

First, let’s limit this discussion to companies whose ownership or use of real estate is incidental to their business activity, not companies for whom real estate ownership is central to their business activity.  This discussion would apply to companies who use office or industrial buildings as opposed to companies that are in the business of leasing property to other companies.

One of the key principles in business valuation is risk: the risk perceived by investors associated with a particular asset or asset type (and the cash flows it produces) will determine the rate of return required by investors to induce them to take on that risk.

Broadly speaking, real estate – as an asset class – generally enjoys a lower perception of risk and a lower required rate of return than a non-public business investment.  What that means in practical terms is this: if you require a lower rate of return from an asset, you will be willing to pay more to acquire its income producing capacity than you would another asset with the same income producing capacity but higher risk.  Therefore, lower risk equals higher value.

The primary reasons real estate is seen as lower risk are intrinsic value and marketability.  Real estate has an intrinsic value, which can be identified regardless of how that real estate is being used at any given time.  Businesses, on the other hand, usually include a component of ‘goodwill’ in their value – often referred to as blue sky – which places the enterprise value higher than the sum of the intrinsic value of the assets used by the business.

Real estate, in part due to its intrinsic nature, also has a well developed market, where values, sellers, and buyers are identifiable.  Businesses have different values to different types of buyers, and have a significantly less developed marketplace.  Therefore business interests are generally considered to be less liquid than real estate.

If we attempt to value a business with the real estate, we are blending two asset types into one valuation, which may result in a portion of the earnings being over valued or under valued.  It would be equally incorrect to value the business with the real estate, and then attempt to subtract the real estate appraisal value from the total value. 

The real estate must be ‘adjusted out’ of the business financials, and appraised separately.  How is this done?  It is very simple to do in most cases.  On the balance sheet, the building (at cost, as well as any associated accumulated depreciation) and land are removed from assets.  Any mortgages associated with the buildings or land are removed from the liabilities.  On the income statement, depreciation from the building is removed from expenses, interest on the mortgage is removed from expenses, and a new deduction for a triple net lease payment is added to expenses.

A triple net lease requires that the tenant pays all expenses related to the building, including utilities, maintenance, insurance, and property taxes.  These leases have historically averaged 9% of the fair market value of the real estate per year.  This is called a capitalization rate, or ‘cap rate.’  In periods of low long term interest rates (such as now) cap rates have averaged 6.5 – 7.5%.  The more specialized the property is, the higher the cap rate will be.  Office and retail space usually has the lowest cap rates (because tenants are easier to replace), while specialized industrial sites will require 10-20% higher than average, depending on the degree of specialization. 

After these adjustments are made, the balance sheet equity and net income will only reflect the results of the business activity, and not any benefit of real estate investment.

I hope this discussion helps you understand why and how we separate the real estate from the business when valuing a business.

Brian Murray CPA/ABV, CVA specializes in business valuations and merger and acquisition consulting, and has served as an expert witness in court.  Please call Murray & Roberts CPA Firm SC at (920) 225-6436 to find out more or visit our website, and click on the BUSINESS VALUATION link.  Go to now for a fast and affordable business valuation report prepared by Brian Murray.

Sunday, April 20, 2014

Business Valuation: Get a Better Value

Get a Better Value

Why the Murray & Roberts Calculation of Value (found at is the best in the industry

Everyone claims their product is the best: the best engine oil, the best cellular service, the best hand-held power tools.  Isn’t Murray & Roberts claim that their Calculation of Value product, the ‘MRCOV,’ is the best among its peers more promotional puffing?  Actually not.  We can prove it.

We can prove that the estimate of value produced by our product has a higher probability of reflecting the true value of your business than our competitors.  The answer is printed before you in black and white.  Most CPA firms offering calculation of value services provide a sample report on their websites (as we do).   We downloaded them and compared them to ours.

These reports tend to be full of industry jargon, non-specific legalese, and wordy disclaimers, which makes pushing through them difficult (we’ve tried to be better than the industry here too, but we also have lawyers.)  It will become evident as you read our competitors’ reports that they employed one method only – the income approach – to determine the value of your business.  The MRCOV calculates the value of your business using all three of the standard valuation approaches: asset, income, and market.  Obviously using three approaches to determine value is much more comprehensive than just one, and has a higher probability of determining the most accurate value.

Further, the MRCOV is the only report which also considers external industry data from two separate and widely recognized sources of industry research.   Our competitors’ reports did not include any external industry data into their analysis.  The MRCOV also considers: the expected future growth rate of the business, customer concentrations, optimum capital structure, and excess/under working capital.  Most of our competitors did not factor any of these significant conditions into their estimate of value.

The fact is, the limited procedures conducted by our competitors are so extremely limited that there is a high probability their calculation of value will fail to consider business or industry conditions that would materially alter the value estimate of your business.

In developing our COV product, we took sample data from dozens of full valuation reports prepared by our firm and honed our mathematical model until our calculation of value consistently produced value estimates within 5% of the values determined by full valuations.  Our MRCOV in most cases will produce an estimate of value within 10% of the value arrived at by full valuation.  At a cost of only $499, it costs less than 10% of most full valuations - an amazing value.

Find out for yourself at  

The MRCOV is an excellent tool for wealth planning, business investment planning, goal setting, and more.  

Brian Murray CPA/ABV CVA
Murray & Roberts CPA Firm SC

Friday, December 6, 2013

Best Value: Expert Witness or Hired Gun?

Expert Witness or Hired Gun?
Business Valuation in Divorce

Your client is in a contested divorce.  Included in the marital property is a very profitable consulting firm.  Your client is the primary operator of the business, and wishes to own it exclusively after the divorce.  The spouse has no interest in owning the business after the divorce.  Is it in your client’s best interest to obtain the lowest valuation of that business you can get?

One of the senior partners at your firm suggests a business valuation expert from a large local CPA firm, saying with a wink “Harry will get the number you need.”  He also tells you that Harry has served as an expert witness for your firm more than one hundred times over two decades.

You decide to check with your CPA also.  He refers you to Cathy, a CPA with valuation credentials and ten years of experience.  Cathy works for a small firm that specializes in business valuation.  She rarely serves as an expert witness; the majority of her work is related to the buying and selling of businesses.  After you call Cathy and explain your circumstances, she tells you that she can accept the engagement, provided you understand that she will not steer the outcome of her analysis in one direction or another.  “My number is my number,” she declares.

Which expert will better serve the interests of your client?  Many attorneys will recommend hiring the expert who will give you the answer you want.  They will argue that most of the time the judge will split the difference between the two values, because the judge will assume that both reports are equally skewed.  Therefore, if your report is not equally skewed, you will be ceding ground to the opposition.

Believing this logic requires that you must also believe one or more of the following statements is also true:
  1.       Business valuation reports are so inherently technical that an accurate report with sound logic is indistinguishable from one that is not.
  2.       Judges are incapable of recognizing the differences between a sound valuation report and one that contains inaccuracies.  Further they are equally ill equipped to discern the significance of the expert witnesses’ criticisms of each others’ reports.
  3.       The credibility and experience of the expert witness is far more important than the quality and accuracy of their work.  Judges, not being able to discern a good analysis from bad, will evaluate the experts based on their credentials and experience, and will weight their testimony based on their relative credibility.

Based on my experience and my readings of judicial opinions in valuation cases, all three of these assumptions are false in the majority of cases.

Valuation reports are inherently technical, however the logic applied in a well-written report should be understandable to anyone with a solid grasp of standard financial investment principles (return on investment, present value, etc.)  Given that judges have the opportunity to read two reports regarding the same company, hear the authors’ explanations of their logic, and hear the experts’ criticisms of each others’ reports, most judges are very capable of evaluating the merits of an expert’s opinion.  Most judges will also be able to identify and quantify those little inaccuracies that tend to skew a conclusion of value in one direction or another.  Judges will also base their opinion of the expert witnesses’ credibility – in part – on the quality of their report, their testimony, and their responses to cross-examination. 

The very foundations of valuation practice are the product of judicial opinions in cases arising from a tax break offered to companies hurt by the enactment of prohibition.  Several of the IRS most prominent Revenue Rulings are the product of judicial opinions.  Judicial opinions have continuously served as a guide to professionals’ best valuation practices, with particular emphasis on the most contentious theoretical topics.

Choosing the ‘hired gun’ will cost your client more, in most cases.  If you present a valuation report with well-substantiated logical conclusions, the opposing side may accept your expert’s opinion of value.  In most cases this would dramatically improve the chances for a negotiated settlement, saving your client significant time and expense.  Even if the opposition does not accept your expert’s opinion out of hand, after hiring their own expert they may conclude that your value estimate was reasonable, which again increases the probability of a negotiated settlement.  If your report is highly skewed, you have almost certainly assured your client an expensive court battle involving multiple expert witnesses, depositions, and court appearances.  Finally, a skewed report may cause your client to have unrealistic expectations, which frequently result in disappointment.

It is very probable that the estimate of value in a skewed report (which inherently contains some inaccuracies or omissions in order to reach its skewed conclusions) will be completely disregarded if a knowledgeable judge is comparing it to a well-written reasonably valued opinion.  You may argue that your client hasn't lost anything in such a case.  I disagree.  Because the judge has completely accepted the opposing side’s value, you have lost the smaller more realistic negotiating opportunity that reasonably exists in every company.  Your client has also spent tens of thousands of dollars more to achieve a result that they may have obtained months earlier.

Brian Murray CPA/ABV, CVA specializes in business valuations and merger and acquisition consulting, and has served as an expert witness in court.  Please call Murray & Roberts CPA Firm SC at (920) 225-6436 to find out more or visit our website, and click on the BUSINESS VALUATION link.  Go to now for a fast and affordable business valuation report prepared by Brian Murray.

Friday, November 2, 2012

Business Valuation Techniques: Best Comparable Transaction Analysis

Selecting Comparable Companies/Transactions

Many appraisers prefer the guideline company method because of the quantity and quality of data available about the selected company or companies.  Some appraisers will review hundreds of companies searching for the one most comparable to the subject company.  This, however, is also the problem.  We are lured by the data to over rely on one or a few comparable companies.  

It is impossible to know all of the factors contributing to one company’s value as of a given date by reviewing its financial data.  Circumstances involving key personnel, large customers, proprietary technology, and the condition of equipment all may have influenced the share price or transaction value.  Was the transaction hostile, or for the benefit of upper management?  Did the transaction incorporate synergistic value which allowed the buyer to pay a premium to fair market value?  Perhaps the most significant question would be: what were the short and long term growth rates of earnings expected by the investors? Far too many factors are unknown to pin an estimate of value to a single comparable.  Valuing a company is not like valuing a residence or a piece of real estate.  We can’t just walk through the place and have a look at the kitchen floor.

The risk of arriving at an erroneous conclusion of value (or, a highly erroneous conclusion, given there is no ‘right answer’ in valuation work) is increased due to information affecting transactions that is unknown to the appraiser.  Therefore, the probability of unknown information skewing an estimate of value derived from the Market Approach increases as the number of companies compared to (‘the group’ of comparable companies) decreases.  The unknown factors present in individual companies are diminished or ‘washed-out’ as the size of the group increases, just as a diversified portfolio of securities reduces the unsystematic risk associated with each security in that portfolio.  This principle is true when applying either the guideline company method or the transactional data method. 

We cannot claim to know all factors pertaining to an individual company, but we can reasonably assess the conditions present in an average company given the industry.  We can more reliably estimate the expected growth rate of earnings of an average company in an industry than we can estimate the expectations of investors for a specific company when limited information about that company is available.  Today, due to expanding databases, we can select a large group of companies with many factors similar to our subject company; industry, size, profitability, etc.    

Ten to twenty companies is a sufficient size to substantially reduce the risk of an individual transaction skewing the result.  It should be comprised of the most comparable companies identifiable.  The subset of companies should be limited to those in a reasonable size range and in a similar profitability percentage as your subject company.  Transaction date is less significant than industrial similarity and size.  According to Ibbotson’s Stocks, Bonds, Bills, & Inflation, historic equity returns do not indicate clear patterns or trends over their 80+ year period of data collected, and are better characterized as a ‘random walk’ from year to year.  For this reason, date range does not need to be limited to transactions within a few years of the valuation date.  Depending on the industry, ten years is a reasonable maximum.  Industry conditions may change substantially in more than a decade.  Those changes could impact investors’ long-term perceptions of risk for that industry.    

Geographic limitations should be applied judiciously based on the nature of the subject company.  If a company’s customers, suppliers, and competitors are nation-wide, then geographic limitations may not have an impact on the operation of the business.  Unnecessarily restricting a search to a geographic region could limit the number of companies in the resulting sample. This may cause the acceptance of a broader criterion of search characteristics (thereby reducing the similarity of the comparable companies in your group to your subject company) to achieve a reasonable group size. 

Using the Data

Many experts will calculate key ratios or multiples (Price to Sales, Price to Earnings, Price to Gross Margin) for each comparable company, and find the medians and means of those ratios.  Medians are often preferred to means because medians are not skewed by outliers.  Means are also useful because they allow for the calculation of the average deviation percentage of the mean.  This is a useful measure of the dispersion of the data in the group. 

The less divergent the data is within the group, the more consistent and reliable the median or mean produced.  An average deviation percentage less than 20% indicates highly consistent data, and above 50% is highly divergent.  The degree of consistency in the data is a measure of how reliable the estimate of value arrived at using the Market Approach will be, and may indicate to the appraiser the degree to which they may rely upon this approach in their final conclusion of value.

The median and mean ratios are applied to data from the subject company to arrive at a transactional value.  Problem: valuing the subject company based on an earnings multiple derived from the group, effectively applies the group’s expected growth rate of earnings to the subject company.

Applying a median multiple to the subject company may be applicable if the company’s performance is comparable to the median company in the group.  If this technique is used, adjustments to the resulting value should be made for capital structure and excess assets to arrive at an equity value comparable to other approaches.  If the subject company has a short or long term expected growth rate that is substantially different from the group, then applying the median Price to Operating Income ratio of the group to the expected operating income of the subject company may not produce a reasonable estimate of value. 

A comparison which allows the appraiser to factor out growth can be derived by taking the analysis of the median/mean comparable company a step further.  In the following example, median/mean data of the group was used to calculate a discount rate applied to the median/mean company earnings.  This discount rate can be directly compared to the discount rate determined in the Income Approach as a measure of reasonableness for both approaches.  The company can then be valued using the income approach formulae, except the discount rate applied to the future expected earnings would come from the median or mean company data of the comparable group.  This technique allows for variable rates of increasing or declining earnings to be accounted for within the Market Approach.  This is not a blending of approaches, because the discount rate arrived at in the Market Approach is completely independent of any other approach.


In the table below, two ‘companies’ are created from the group, one representing the median of the group, and the other the mean.  Acquisition debt was estimated at one third the purchase price.  The anticipated growth rate of net cash flows was estimated to be 4%, showing little growth above long term inflation.  Cost of debt was estimated to be 7%.  Using the Single Period Capitalization Method, the Return on Investment (ROI) of the median company is 25.7%, and is 17.2% for the mean company. 

Return on Investment Analysis
Operating Income
Op Inc/Sales
Price/Op Inc
Est Aquisition Debt
Estimated Growth Rate
Estimated Cost of Debt

Given the large range in size of the companies in the group, the largest companies can have a significant impact on the group mean (company #18’s purchase price is larger than the total of companies #1-12).  Further, the largest three companies’ ratios are all substantially higher than the group averages.  For these reasons, the median company is a better representation of the group overall.

Based on the estimated return on investment of the median company in the 18 company group of 25.7%, the 28.23% required return on investment for equity capital in XYZ, Co. stock derived from the Income Approach appears to be a reasonable basis for valuing earnings.

Brian Murray CPA/ABV, CVA specializes in business valuations and merger and acquisition consulting, and has served as an expert witness in court.  Please call (920) 225-6436 to find out more or visit our website, and click on the BUSINESS VALUATION link.  Go to now for a fast and affordable business valuation report prepared by Brian Murray.