A colleague of mine was recently approached by one of the Big 4 inquiring about his business. After a few brief conversations around his financials they came back to him and offered him a very specific number to buy his business.
He remarked to me, “They knew more about my business and what it was worth than I did. I had no idea.”
Ask 5 business brokers what your business is worth and you’ll get 5 responses. Ask 5 investment bankers and you will get 25 responses.
How do the MSO’s know exactly what your business is worth? How do you value a business?
There are three common ways I see collision businesses valued: by discounted cash flow (DCF), the multiple method, or by asset value.
Let’s break each one down.
The multiple method is by far the most common way I see collision repair businesses valued.
You probably heard it before. “Did you hear about Joe’s Auto Body – they sold for 5 times!”
But what does that mean?
The multiple method most often refers to a sales price expressed in terms of EBITDA. Say for example your business generates $200,000 of EBITDA every year and you receive an offer for $1,000,000.
Congratulations, you just received a 5x offer. Not bad. ($1m ÷ 200k).
The multiple method is a quick and easy way to determine a value for your business. It also allows for easy comparisons across different businesses.
It also allows both a buyer or a seller to evaluate the price of a transaction relative to other transactions in the same industry.
Essentially the multiple method is equivalent (and often referred to as) a “comp”, or a comparable transaction.
Using the multiple method is widely used. It is efficient and effective but also has limitations. We will discuss some of those limitations in upcoming letters.
(Editor’s Note: Read how to calculate EBITDA)
Discounted Cash Flow (DCF):
Valuing a company using a DCF model is theoretically the soundest and best way to asses a business.
The DCF method is a much more detailed and nuanced approach to valuation. It is based upon the premise that the value of a business is not what happened in the past, but what is projected to happen in the future.
Building a DCF model can be complex. MBA’s go through entire semesters learning how to build DCF models.
The corporate development analysts at the Big 4 also build DCF models as well. So do the private equity groups.
It is in your best interests to understand what a DCF model does, and how it works.
Without getting into the fine details, you can think about a DCF model in the following way:
Start with free cash flow. (For the financial purists, that is unlevered free cash flow). For the rest of us, a good shortcut is EBITDA – CAPEX.
Think of CAPEX of what you reinvest in your business every year. In other words, what you will spend on equipment, machinery, maintenance, etc.
Now, project this number (EBITDA – CAPEX) forward. What do you think this number will be next year? And the year after? And the year after that?
The way the DCF works is that it takes your projections and discounts them to give you the present value of the future cash earnings.
The sum off all these discounted cash flows is the value of your business.
What is a discount you ask? Think of it as the opposite side of an interest rate that accounts for risk as well as the time value of money (more on that below).
Discount rates can become very complicated very quickly for the uninitiated. Every discount rate is unique to every company based on factors like size, risk, capital structure (debt vs equity), corporate tax rates, variability of returns and even things like the the interest rate on government bonds.
Specifically a discount rate is determined by the weighted average cost of capital of the firm, or WACC. WACC is determined by looking at the weighted average cost of both debt and equity.
The cost of debt is pretty easy to calculate – it is the average interest rate for any debt you have on the business. Estimating the cost of equity is a bit more difficult, especially so for private companies, and includes such nuances as levered and unlevered betas, market risk premiums, control premiums and discounts, small company marketability discounts and even industry average debt/equity levels. The formula to derive the cost of equity is formally known as the capital asset pricing model, or CAPM for short.
Without getting too deep into the financial weeds, a good shortcut is to assume discount rates for collision repair businesses range from 15% – 35% or more, depending in the above factors. If you see rates at either the high or low end of that spectrum it may be worthwhile to ask for additional clarification.
In general, the larger and more established you are, the lower your discount rate. The smaller and riskier you are, the higher your discount rate.
(For those of you with your mouth open in horror at my extreme oversimplification, I apologize. Email me and we can discuss further.)
The power of the DCF model is that it cleanly accounts for a conundrum that is easy to overlook. With each passing year, your money becomes worth less and less. A dollar today is worth more than a dollar tomorrow. That is called the time value of money.
I could write chapters about this, but many far more intelligent than me already have so I’ll leave it here currently.
In some situations a business is sold for the value of its assets. You have spray booths, office equipment, frame machines, etc. If you sold all that equipment separately, how much would the equipment be worth?
Be careful with this approach – it often yields very low values. Normally deals that use asset values are for businesses that are on the ropes.
Valuation is a tricky game, and there is MUCH more that goes into it than what I described. I’ll talk about that in future letters.
In the mean time, if you do need some valuation work done, feel free to reach out to me. You can email me on the About section of the page. http://supplementcollision.wordpress.com/about/
4 thoughts on “3 Reasons MSO’s Know Exactly What Your Business is Worth”
Great summary. Thanks!
Great summary Brad, very proud of you.
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