Monday, February 22, 2016

How many years of results do we average when pricing a business? Viewer Question- David C Barnett

A great question: When we evaluate a small business for sale, how many years of results do we average? It depends…

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Good day, it’s Dave Barnett from I’ve got another question today about buying a business. This question is from Bob.

Really the question is about evaluating businesses and Bob wants to know when he looks at a business, how many years of results should he average out when deciding what kind of numbers to use. So if sales, you know change every year, do we average out, for example, three years of sales or five years of sales, what averaging do we do to the numbers? and then the truth of the matter is, it’s maybe frustrating answer for you Bob, but it depends. and this is what it depends on it depends on the trend. Let’s take a look at the white board.

Aright Bob, so what I’ve done here is it created an example company and we’re going to call this one the Growing Company. Now each one of these columns represents a year and so we have six years of data here, and then the dotted line is our forecast year, so it’s our best guess as to how the upcoming year is going to shape up. Now normally you’re evaluating businesses based on financial statements which means that if the financial statement for this last year is in your hands, it means you’re already into that forecast year. So you may be able to look at least a few months of results for the upcoming year and see if it looks like it’s going to be performing as well as prior years now, in this case what people sometimes want to is say looks let’s just average together a bunch of years but in realty that’s not the best way to look at a company.

The most recent year of performance is the best indicator of the performance of the company and if I’m evaluating a business that has sales that were continuously growing year after year. And profits that were lined up just as nicely growing year after year that would I would actually do as I would probably do it weighted average and I would probably put fifty percent of the weight on the most recent financial statement. I might put ten percent of the weight on the forecasted year. If we’re reasonably certain that it was going to perform as we expected. And then I might put some waiting on these past years but I wouldn’t make it an even weighting. I might put 20% on the year before this gives me 70 and then I might put 15%. And then this gives me 60, 80, 95 and then I might put 5% there. So I would use a weighted average with the majority of my weighting being on the most recent year. So this is an example of a growing company.

Let’s take a look at some other example. Here we’ve got the opposite situation. We have a declining company. We have sales that are going down every year and we’re projecting another small decrease in sales and we got profits that are going down every year as well. This is a completely different situation if you we’re trying to sell a company like this. You would probably want to make some sort of argument to use even average of several years of results if you were buying the company though, the very first thing you’d have to isolate is why are the sales declining. Is there a reason why this industry is falling out of favor? I mean are you buying a video store in the modern age of online streaming movies for example. Is it just the industry is dying off or are there problems with the way the company is managed and run that maybe you could fix. You never pay for something that could be as I mentioned in many of my other videos, you always pay  for what you get.

So in this case if I was doing an evaluation from bob’s point of view as a buyer. I would actually want to have all of my weighting on the most recent years and in fact you know I would probably do something like 85 and 15 so if I was projecting even more decline in the last year I want to have some weight on that. So that we drag down the overall fact of the different year’s performance. This company in the future year has very little in common with this company back here. This company was bigger, had more sales, probably more customers, maybe more employees, or profits, etc. then this company over here there is a material difference between how these companies operate.

Let’s take a look at 2 more examples. Here’s another example and I’m going to call this one Uncertain Trend. And what we see here is a bunch of moves up and down up and down. There is no real consistency to the performance one year after another. We can clearly see that there’s an increase or a decrease in what’s going on in this business. Now if we can identify why? so for example a ski resort maybe has its revenues and profits directly tied to the amount of snowfall every year that can give us an indication as to why the performance jumps all over the place but from the point of view of a buyer who wants to buy the business, your concern is how do I average these numbers together? Again in all of the different situations I’ve looked at. The last full year performance is still your best indicator of what you know What the business is worth how the performance is. So in a case like this, I would actually want to put a little more weight than the first example, so I might put 60% weighting on this year and then maybe 15 and 10 so this would give me 75-85 and maybe five here and 10 over here. So were still using an average in this case we’re getting more of a sampling of other year’s performance but we’re still primarily look at the last full year results. Given that the most recent performance is in most likelihood the most relevant performance to how the company is going to perform. What you’re probably noticing is that in none of these cases have I simply taken four or five years of results and just average them because, quite frankly, a company five years ago is very different from the way that the company operates behaves the market condition of a company today and so as we get further into history the results increasing become less relevant.

I always love it when people say ‘’Hey it’s a great company, has been around for eighty years. Well you know a lot of steel mills have been around for eighty years and a lot of other big industries that don’t have such a great performance track record in today’s day and age. the fact of the matter is the longevity of a company may be good for its’ story, its marketing, its number of customers, the people who’ve heard about it but what we’re really concerned about is how this company operating? How does it perform today and what is the likely outcome of the company going to be in initial time period when we take it over as buyers.

Let’s take a look at another example that’s a little bit different. Alright in this last example I’m going to call this one Rapid Growth Example because I’ve had a few cases recently that I’ve worked on where this has been the scenario. You’ve got companies that because of really unique intellectual property have been able to create products. Where they’re the only player and they create significant value for their customers such that everyone in a given industry wants to switch over to their products. So there is growing demand from all over the world for these products. People want to sign on to be customers and every year the company is logging incredible growth like 30%, and 50% and 70% and a hundred percent and 150% growth. Year after year now that kind of growth creates certain challenges obviously as far as cash flow and receivables and things. But in some industries are able to demand deposits up front and things like that. You can actually work with that kind of growth.

Now in a situation like this, This company in the final year literally has nothing in common with the company of a few years ago. And in this case what I was suggesting to the person who wanted to have the business evaluated, what is that from the sellers point of view he’s going to want to drum up the fact that the future is so bright and that this thing is going to carry only probable we’re like crazy in the future the buyer obviously wants to get as a good a deal as you can as this thing grows and grows and grows, clearly the business has more and more and more value in a case like this, would actually ended up happening was I put eighty percent of the valuation on the final year and 20% on the future forecasted year. With the idea being that this valuation would have to be updated its a deal didn’t happen within a few months there’s going to have to be updated again because the company keeps changing in a material way as we move forward into the future and not only is this kind of growth and give you sort going to base of your evaluation on the biggest sales and profits numbers but the sellers also going to come and top-ranked multiple given the fact that the company to such a shinning jewel that a lot of people obviously in a way to get their hands on.

So Bob I hope this helps your question do we averaged the last three years? No I’ve never used sort of an average of any number of year, it’s always got to be a weighted average you’re always going to want to put a maximum sort of weight on the most recent history and if things are going down in a big way or up in a big way than your want to consider maybe even forecast year as the company changes in a material fashion. anyway I hope this was helpful and if you have any other questions about how do you buy or sell small business come to my blog site in check over my business buyer course or and soon I’m going to have my exit planning course which will be online come to my blog site and get yourself up for that one as well. Have a great day

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