Last time, we discussed five of the 10 characteristics of difficult-to-value companies. As previously mentioned, the valuation process is dynamic based on varying factors, including prevailing market conditions, operating results (where have they been and where are they headed?), customer and vendor changes, the company’s competitive advantages (and weaknesses), etc. Beyond these typical factors, however, there are other characteristics that some companies possess that introduce additional challenges into the valuation process. Some of these traits may be within the owner’s control, and others are driven by the market.
Having said that, here are five more characteristics of difficult-to-value companies:
Characteristic #6: The company earns most of its profits in a specific calendar period of time: Many retail businesses fit into this bucket, for example, as they generate most of their profits during the holiday shopping season. It is challenging to predict the company’s results for the entire year as it manages the “lean” months through most of the year in anticipation of the busy holiday season that will make or break its entire year, i.e., the “seasonality factor.”
Characteristic #7: The company has a high book value but declining earnings: An example that comes to mind is a retail client from several years ago. The company’s earnings and cash flow were declining, but the company was profitable and had a strong book value. It was difficult to value the company based on its earnings and cash flow because they were decreasing annually, and we could not determine if and when the earnings and cash flow would bottom out. A valuation based on adjusted book value with perhaps a slight discount to book value to account for the inadequate return on book value, i.e., negative goodwill, was one approach since the company was profitable but had decreasing earnings and cash flow.
Characteristic #8: There are too many owner expenses that are hard to verify as add-backs: Owner expenses are typically a difficult-to-quantify line item as they often include commingled travel and entertainment and other expenses that cannot be objectively identified and confirmed. An example would be an owner who hosts events to entertain clients or prospective customers. The owner might purchase pricey gifts for raffles and/or door prizes, and while they are at it, buy two or three pricey items for themselves and/or family members. The extra purchases are part of the “cost” of entertaining, but not a real cost, and one that would go away if the company were sold. When valuing the company, however, how defensible are these add-backs and how can they be documented with 100% certainty?
Characteristic #9: The company relies on high-ticket-value-sales: Similar to a commodity-based or a cyclical business, a company that relies on the sale of high-priced items, like heavy-capital equipment, is difficult to value because demand and earnings and cash flow fluctuate from year-to-year. As such, it can be challenging to project the company’s future earnings and cash flow with any certainty without also understanding customers’ appetite for its high-ticket products. In addition, customers fluctuate significantly from year-to-year, further complicating the ability to evaluate the consistency of earnings and cash flow from year-to-year.
Characteristic #10: There are unmeasurable assets or liabilities: In today’s “knowledge economy,” it can be challenging to measure a company’s actual value because of the number of intangible assets and liabilities that cannot be quantified. Put another way, sometimes a company’s most valuable assets, whether they be patents, management experience, research and development (R&D), or highly specific business processes and systems, are intangible. As such, they have no natural place on the company’s balance sheet and are difficult, if not impossible, to measure as part of the valuation process. Ultimately though, those assets must generate earnings and cash flow and must do so on a consistent basis in order to incorporate those assets indirectly into the overall value of the company.
In short, difficult-to-value companies can be more challenging in terms of setting valuation parameters and expectations for the owner, but there are methods to overcome those difficulties. The owner needs to understand that the valuation conclusion implies a structured transaction. Hopefully over time, the owner will receive the entire valuation. In this case, the buyer is happy to pay this price because the agreed upon earnings and cash flow hurdles have been achieved by the company.
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