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Comparables
Comparables are similar to rules of thumb, in that you compare your business to other businesses. The strength of this method is that you are comparing your business to actual transactions. If you get a set of 30 comparables and find that they sold for an average of 1.7 times cash flow, with a low of .75 times and a high of 2.9 times then your business is unlikely to sell for more than 3 times cash flow.
Problems with Comparables
I ran a report from a prominent data provider (who now offers free valuations based solely on these comparables) at the request of a buyer who was purchasing non-emergency medical transportation companies. Let's look at some of the issues with the report. To begin with, although the data provider was a reasonably large player and the database contains about 17,000 transactions no category narrow enough to match what my buyer was interested in, so we ended up using a category titled "Services — Local Passenger Transportation." We got a result based on 34 sales over a 5 year period, a period that included wide fluctuations not just in the market for small businesses but also in things like the price of gasoline that had disproportionate impact on this industry.
The average Cash Flow Multiplier was about 2.4; the median was 1.9. So, could my client conclude that a seller who was asking 1.5 times EBITDA was a bargain and one who was asking for 3 times EBITDA was asking top dollar? Not really. If we look at the descriptions of the businesses and eliminate businesses such as taxi companies, airport limousine services, and bus companies and we limit ourselves to transactions that had occurred within the last year, we find only 2 transactions are left, not enough to base any real conclusions on. Their multiples of cash flow were 2.47X and 3.64X.
What is more important than what we know about these companies is what we don't know. In this report we have no idea how strong the balance sheets of each company was and medical transportation is a capital-intensive business. Even if we had the balance sheet, there are many things that can affect the numbers on that balance sheet making two balance sheets hard to compare without an in depth analysis. For example, choosing a different method of depreciation can materially affect the value of the balance sheet.
Lack of consistency in data also affects the accuracy. Does cash flow include or exclude a fair salary for the owner, (and who defines fair)? Were cash and accounts receivable included in the sale? Was the payment in cash or did the seller receive a note? How were payments contingent on the future performance of the business valued? Were there adjustments made for employment contracts at non-market rates?
There are also things that are never reflected on a financial statement. A business in a rural area will sell for less then one near a major city. A business that is growing is more attractive than one that is not. Unless you know a lot about the businesses being compared you can't decide how relevant the information is.
Most business comparable reports don't contain enough data to allow a reasonable assessment of true value. It's like trying to assign a value to a house based only on the square footage, the number of bedrooms, the number of bathrooms, and the fact that it is in Los Angeles. To get real value you would need to know what shape the house was in, what neighborhood, etc. Anybody who tries to value a home on the basis of broad averages would be laughed at. Unfortunately, businesses that are even harder to value fairly based on comparables are often valued in just that way.
Also, unlike in real estate, where a purchase price is easy to evaluate in business transactions the true price can be hard to determine. What is the real value of a note from the buyer. an earn-out agreement, a consulting agreement, etc.? Recognizing this problem, some of the better comparable data sets have a field for what percentage of the purchase price was paid in cash at closing, but there's still no perfect way to value future payments many of which may not happen until years after the sale.
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