Ep8 - Time in a bottle - Effects on a business valuation

Welcome back. This is the ESOP guy and let's continue on this journey to an ESOP. This podcast is for those that are thinking that they might want to consider an employee stock ownership plan, either as a growth strategy, and a succession strategy, an exit strategy, um, I mean we were a combination of all of those. Today's episode is going to be really interesting because it's going to cover uh what one of the most important aspects of any business transaction, and that's the business valuation. And it's going to be an episode that's geared around the timing of your business valuation. If I could save time in a bottle, the first thing that I'd like to do is to save every day until eternity passes, and then to spend them with you. So one of my favorite songs of all time, Time in a Bottle by Jim Croce. What can I say? I'm a 70s kid. I grew up with this genre of music, and every time I hear it, it just makes me think of things and as I heard it, I thought of this issue of the timing of your evaluation. As a potential company is going to sell to an ESOP, this podcast, this episode is going to go into, does it matter? What time of the year, what does it matter what time of the, the economic cycles we're in? Does it matter, um, to you and your business valuation? And so, obviously it, it's going to matter as I set that question up, it's a loaded question, but we're gonna consider how your business valuation, your multiple based on what your ebida is, gets calculated and how it's affected um by the changes in the marketplace with interest rates and market changes. So, if you like what you hear, please subscribe and share it with a friend. So I'm at the dentist recently. I'm getting this much-needed work done on my teeth. And if you're like me, that I put this off as long as I possibly can. It's kind of like buying a new car. I don't like doing it. It's painful and I just avoid it. And I should not, definitely with the dentist, but so I have, and so I needed to go and I was in this place where I was, I was more desperate, um, because I just had to go. During this, what I would call very long and arduous dental procedure that I had to undergo, the dentist was assisted by the, the dental assistant. And that included both of them working on my mouth, included shots, um, mouth guards, um, the, the whole nine yards of everything you need to, um, to fix some major teeth problems. And I guess because I was so desperate with all the pain that I had, I did not mind when the assistant. Drop the dental hose, you know, the, the hose they use to suck out all that stuff in your mouth. Drop that on my face during the operation or during the procedure. I was, however, a little concerned when at the very end of the procedure, the dental assistant had worked through. I had to, I had to get a temporary crown, and she had worked on the temporary crown and right before she put it into my mouth, and you know, to fit it in there, um, it dropped on the floor. And so I kind of went back to like, uh, you know, I just have to get this done and I have to get out of here. And, but at the end, she was very apologetic and she said, I am really sorry. I'm just very freaked out by the, uh what's happening in our country with the coronavirus. So, We worked through that, we talked through it and it just, it just reminded me that the times that we're living in right now are, are, are really unprecedented and as we go through this crisis in America, how does this affect in terms of the timing that we're living in right now, how does this, how does this affect your business valuation? And What I want to get into is, is giving, I'll give you some, what I'm gonna do is give you some information and then really go into how it affects your business valuation and, and the first part is to understand the, the terminology and what's behind the curtain of this terminology of of multiples. So a multiple. Is what the company trades for on an enterprise value based on some metric within the company. Most of the time when we're talking about multiples, the, the terminology is going to focus on your EBITA, so your earnings before interest, taxes, depreciation and amortization. In an article that I pulled by BVR in 2019, they were quoted under the study that they did, finding that EBITDA multiples are highest for the information sector, and they had quoted at 11.1 times EBITA for the mining, oil and gas extraction sector at 8.6 times. Then they looked at the lowest multiples for companies that do food services, and they were at 2.5 times. And then they, they looked at their whole study and they said in the median, multiple across all industry sectors, statistically, Is 3 times. So that's 3 times the Ubida. So when we start talking about multiples of EIA. Um, we need to kind of bridge into the idea behind what, what are we really talking about? And the terminology is, is thrown around a lot, but what we're talking about is what we call as valuators the market approach. And the market approach takes comparable data that is available. Based on the current market conditions and when you're looking at the market approach for your valuation for a company, what you're really doing is looking at companies that have sold, and you can look at the multiple of what they sold for and use that data hopefully to extract back to your subject company and come up with something that's comparable. So when you have somebody that says, I sold my business for a say 10 times EBITA, what they're saying is that their enterprise value, which is the cash flow valuation calculated at looking at earnings before interest, taxes, depreciation and amortization. Based on that number, they multiply that times 10. And then they take that number and they multiply it times their existing EBITA. So, so if I have a company with $1 million in EBITA, they're worth $10 million from an enterprise value. So that's the, that's the path and somewhat straightforward in that you, you get the multiples from comparable data and you, you apply those and the evaluator's job is to make sure that they've applied those correctly to a subject company. But, and, and what I find in in talking to companies about their, their business evaluations is this, this idea of multiples gets thrown around a lot. As soon as somebody has, hey, I think my business is worth 10 times multiple of EBITA, um, then they start kind of like, well, they kind of know at that point where they think they know what it is. And and the question I have is, how did the 10 times get calculated? And I just kind of covered the idea that it's calculated through, through the statistical analysis of comparable data. I'm not talking about that. I mean that if I'm a business and I'm buying another business or I'm, I'm, I'm an owner or a private equity group or whomever I'm buying. I have to go through that analysis myself. And even though the studies might show that that's what these companies are trading for, I'm going to have to do my own analysis and to determine what is this real, what's the real multiple for my specific subject company. And so my, my. You know, my, my situation with this in terms of talking about it is, it doesn't make sense that a business that buys other businesses. Um, it's just whimsically going to take a a study and say, well, I'm just gonna pay that. No, they're, they're going to do their own analysis. And so what really I think is interesting about this, this episode is what I want to do is pull the curtain back for people that don't really understand what multiples are. And I do, I do believe this is so important for companies that are going towards ESOP, because there's a lot of thought process behind it. So there, there may be a company that's looking at their existing business valuation based on what their friend. sold their business for and they're very similar, and they've already determined that's their multiple. Um, so, now may, that may be right, and that may be wrong, but I always kind of under the idea that it's better to have more information and really better understand it. So what, that's what we're gonna do today. We're gonna pull the curtain back and really understand what's behind that multiple. Um, and sometimes when we get a valuation report, nobody's really sharing that with you and going through the details, and sometimes they do, and I think it's really important for you to at least, you know, ask the question of your business valuation firm. Now, on an ESOP transaction, what happens, the transaction itself, you're not going to get to see the valuation that the trustees ordering. So you're not going to be able to ask that person a question. You're going to ask, hopefully the, the, the firm that's doing the work for you from a feasibility perspective. To get behind the curtain and really understand the, the mechanics behind the multiple. So, when we look at that, we're gonna then gonna bridge into um we're gonna leave the market approach valuation for a second. Now we're going to bridge into the uh what I would say from an ESOP transaction standpoint is the way the Department of Labor likes to see business valuations and that is using the discounted cash flow method. And what this method does, this is specifically different than a market approach. This is an income approach methodology in doing valuation. And what it does is it includes forecasted cash flow of the subject company. And it takes that cash flow and at present values it back to a current value. In order to do that, the valuator has to determine what the appropriate discount rate is, which is what we're gonna, we're gonna end up spending our time on. So the basic understanding of this method is that it has two main variables. One, we're going to talk about and one we're not. The first we are going to just mention here, and we're not gonna really get into it is normalized cash flow. So my forecast is going to create some level of normalized cash flow. And the other part of the, the, the model is gonna be the risk rating of the cash flow under a proper income approach methodology. The relationship between the cash flow and the risk rating is what we're concerned about. And so if I, if I go back to my dental visit for a second. If I have a patient and, or if I'm the patient in, in the dental office, the more issues I have with my teeth. So the more, say, say that's likened to the more risk that I have with my teeth. If I go into the dentist, Um, with a higher risk rate in my teeth or a higher problems, problems with my teeth, then the experience I have in the dental office is gonna be a lower valued experience. It's not gonna be as good. So if I go in the dentist and I have no cavities at all, and I have no problems, and it's just a checkup, that's a great experience. Hey, how are you doing? Have a fun time, and then you leave. But if it's a, if I've got lots of problems in my mouth, then it's gonna be, um, the value of that experience is gonna be bad. So, in other words, what I'm saying is, That the lower the risk of the cash flow that you have in your subject company, the higher the value of that of that cash flow. And so that's the relationship and it, and it works opposite. The higher the risk of the cash flow, the lower the value of the cash flow. And that's very important to understand the relationship between the risk and the cash flow and how they, they connect in that in that approach and the income approach. So next, we're going to bridge into the idea of creating the discount rate. Now, this is very important because it's going to help us identify the components of what's in the discount rate so that we can then bring in our real example and then talk through what the effect is in the current time of, of changes that we're seeing in the economy. So, in doing a discount rate, One of the most acceptable ways to do a discount rate is to do what we call a buildup approach, which means we're adding various rates, risk rates together, and these are going to include The ones that we're gonna talk about include risk-free rate, market equity premium, small stock premium, and specific risk of the subject company. So the first rate is called risk-free rate. The risk-free rate represents for an investor, what they would expect to earn in an absolutely risk-free environment over a specific period of time. So this is oftentimes compared to like a treasury yield, where somebody buys something in the treasury and they're not worried about losing their money. So, give you an, I'll give you an example of risk-free rates, which come into play with discount rates. In the last 6 months, from a timing standpoint, the Duff and Phelps, which is a company that does um support statistical data support for valuation firms. The Duff and Phelps Company post their risk-free rate about 6 months ago at about 50 basis points higher than it is currently for, for many different industries. So that's going to play a big part in terms of, of how the whole discount rate is going to be put together. The second rate we're going to talk about is the equity risk premium rate or the market premium. This is going to refer to the return, the excess return that investors are going to get in the stock market over the risk-free rate, and it's going to be compared to, so that you can better understand a large, more like a large cap stock portfolio. So this excess return over the risk-free rate compensate, compensates the investor for the additional risk that they're taking. And so this is when we look at this issue with layering rates, what we're doing is we're saying, if I'm buying a stream of cash flow, then I need to at least get back in the marketplace, what I could get back from a risk-free rate. And I also need to at least get back what I could get back. For the risk premium of a large cap stock. Now, with market premiums, many times we're we're looking at that market rate from a an industry standpoint. So say for instance, we're doing a subject company and they are a construction firm. We're going to go to the construction industry data and we're going to determine What in those publicly traded companies, what those returns are going to be. Within each industry, there's going to be a different volatility of of that stock price moving up and down. And so the higher the volatility, the higher the risk of that market premium and the higher the expected rate of return. So I'm getting into a lot of like the technical parts and that volatility is measured by what we call a beta. And so again, the the timing of everything that when we move into a marketplace where there's a lot of movement up and down on prices, the volatility increases and that can definitely affect um our overall discount rate. The third rate we're going to talk about is a small stock premium rate, and this is to capture another layer of risk and expected rate of return for smaller entities. And what the way we get this is by going into the data for publicly traded companies and looking at market caps that are similar to the size of the company through the deciles of those companies being layered from 1 down to 10 to 10B. And so what we do is we assign the right market cap to the subject company, and we find the small stock premium and we apply it to this add up or this buildup approach to build our discount rate. So that's a lot. And then the fourth rate that we're going to talk about is is the specific company risk rate, and that is something that the evaluator is responsible to to determine based on the subject company's unique um risks and the the the layer, the level of those risks in comparison to Uh, other subject companies. So, in, in, in dealing with specific company risk, it may be that they outperform their marketplace from a financial standpoint. So they may be lower risk for that company compared to other companies, or it may be that there's um their company with not a lot of recurring revenue, not a lot of diversity and revenue, and so they may have a higher risk. So the specific company risk has to be assigned by the valuator and those numbers are put together to develop the entire discount rate. So let me give you, let me pull all this together in an example and we're going to isolate some of the variables to make it as simple as possible. I took for this podcast, I took one of the business valuations I did last year, and I analyzed for this company, um, just the change. In the, the risk-free rate. And in the analysis that we did last year, the risk-free rate was, was higher by 50 basis points as I mentioned before. When I brought that back to the normal period of time that we are in right now, that lowered the rate, the, the, the entire discount rate by 50 basis points or by 0.5 point. And when I had last time done the valuation, it was done at a 3.8 times multiple. When I, when I revised the valuation with everything being constant other than the reduction in the, in the discount rate, I came up with a 3.9 times multiple. So in this case, uh having a client or a company that did $10 million in ebita. When I, when I apply the multiple to that scenario, last year it was $38 million this year it was $39 million. Does a million dollar movement matter in your valuation? I think it's a significant move. So really understanding the relationship in the marketplace with these, the factors of things changing, the the company themselves maybe haven't done anything differently. Um, that's where, that's where this becomes really interesting. You, you don't have any control as a business over what's happening in the market, but it does affect your business valuation. And it's very important. When you're going through the process and this journey towards an ESOP, to understand from a timing standpoint, how that affects your business valuation and be up to date on that as often as you need to when it's, when it's significantly moving in different directions, which is what's happening right now with the market changing so much. Specifically, with the changes in the in the stock market, but also with what the Fed has done with interest rates and those absolutely do affect this whole discount rate development of of what your, what your true discount rate is right now. And so when I, when I wrap that together, I really think it's important to, to start to really differentiate. Um, for the business owners and the CFOs and people that are looking at companies that want to go ESOP, differentiate between what your real multiple is. And so if you take what I just told you, and I invert that cash flow with the risk, what I am doing is I'm creating a multiple just like I've giving you the example. So, so you're really getting a more fine-tuned multiple and understanding that does it, does it matter if your company moves up or down by a million dollars? Maybe, maybe that's something you should know about. And so hopefully, this podcast has helped you to understand the relationship between cash flow and risk and the timing of, of what's happening in the marketplace, so that you can better understand where you are in the process of, of doing your own company or picking your own company through an ESOP. And so I go back to one of the episodes, the very first episode that I did on the podcast, which is enough information to be dangerous and I outlined. A, a pre-ESO timeline and the very beginning of that process that that goes that we go through is to build this valuation model and as, as we build it, what's nice about it is we can update that discount rate on a real-time basis, and so that the client is aware of the changes in the marketplace and how it affects their business evaluation. So I would strongly advise that direction, because it really does help to see things that you need to see and be aware of the things you need to be aware of. So once you find the thing. That you like to do, but there never seems to be enough time to do the things you want to do once you find them. So let me leave you with this. That was the end of the, the time in a bottle song, which I, Jim Croce, which I started off with. But Abraham Lincoln said this, the best thing about the future is that it only comes one day at a time. And I think for, for us in America right now and in the world as we go through the, the, all the different changes that are happening, we need to just take it one day at a time. And the podcast itself, this episode is really about isolating the time changes right now, one day at a time. And looking at that with, with. Um, information that really helps you to determine where you are on this journey to an ESOP. So again, thank you for tuning in to the ESOP Guide journey to an ESOP. If you like what you hear, please share it with a friend and subscribe to it. On the next episode, we are going to interview an ESOP attorney and I'm looking forward to that. So tune in for the next episode. Enjoy your day and we'll see you next time.