This is CFO Secrets. The weekly newsletter that takes the best finance ingredients and blends them into a delicious, refreshing CFO smoothie for you.

15 Minute Read Time

In Today’s Email:

• 🧮 How to value a business

• 🖥️ Steve Jobs laying down the law

• 🥇 The other ‘KPI’

This week’s sponsor is …….. no-one. I’m not accepting sponsors.

But that will change soon. If you are interested in sponsoring the next series of CFO Secrets, reply to this email.

THE DEEP DIVE

When Theory meets Reality: What the Textbooks Miss in Valuation Practice

This is week 2 in an 8 week season covering the world of M&A from the seat of the CFO

I once worked for a family business who built an empire worth billions from scratch in a single generation.

All bootstrapped.

They didn’t invent the next big thing. No world changing tech.

Just brilliant operators in a tough industry who built huge moats.

They used M&A masterfully to build an empire.

But here’s the most amazing bit.

They couldn’t name a single valuation method. Not one college degree between them, let alone an MBA.

I have worked with smart people who have been to the best business schools in the world. Dissected valuation methodologies with MDs from every big investment bank you could name. Such as the example I shared last week.

They all made fine livings, and many have had brilliant careers with M&A.

But none were billionaires.

The only people I’ve worked with who have used M&A so successfully that it put a third comma in their bank account, had never heard of discounted cashflow. They didn’t estimate terminal growth rates. And they rolled their eyes whenever anyone said ‘IRR.’

Their approach was so much more simplistic.

They waited and bought assets and businesses at values so low, they couldn’t fail to make money.

They identified good assets being operated badly, and then would wait. Often years, but sometimes a decade plus. Then when the opportunity arose to buy the business at book value or close to it, they swooped

By improving profitability, and plugging it into their core operation, they would make an arbitrage.

They bought at book values and held or sold at an earnings multiple.

They made sure they paid so little, the valuation detail didn’t really matter. Asymmetric risk and return (we’ve heard this two weeks ago).

I tell this story not because complex valuation models are worthless. But because it illustrates the health warning.

Valuation is not a precise science.

If you try hard enough, you can justify any price within a range. Cognitive bias risk is high. Especially when you overlay the conflicts of interest issues we discussed last week.

With that disclaimer, we move this week to talk about valuation methodologies.

This isn’t a comprehensive coverage of all points in valuation. That would take a series of books. But it is a whistle stop tour of the practical considerations in valuation. And at the end, I’ll set out the methodology I use to value businesses.

Let’s start with some terminology

Enterprise value vs Equity Value

Enterprise Value = The value ascribed to the company’s assets on a ‘cash free debt free’ basis

Equity Value = Enterprise Value Plus Cash Balance Minus Debt (And Debt Like Items) Plus or Minus Working Capital Adjustment.

Equity Value is ultimately what would be paid to acquire a business. Enterprise Value allows comparison between bidders on a consistent basis. It ignores any capital structure considerations

Offers for an acquisition are made on an ‘enterprise value’ basis. I.e. Cash on balance sheet and debt outstanding are both assumed zero, and working capital assumed at a ‘normal level’.

A key part of the DD process is to agree a bridge from Enterprise Value to Equity Value. I.e. What level of debt, cash and working capital (vs a normal level) is transferring with the business. This is then adjusted in the valuation $:$.

The definition of ‘debt’ used to get from Enterprise Value to Equity Value is complex. It is not the same as a GAAP definition of debt. Working capital adjustments are a minefield too

There is a lot to unpack in this point, and we will dedicate week 7 of this series to this. Bridging from enterprise value to equity value.

It is because of this complexity, that initial valuation discussions center around Enterprise Value.

The scope of the rest of this newsletter is valuation on an ‘enterprise value’ basis.

Valuation is an Art not a Science

What is a business worth?

The most common answer you hear is: “whatever someone is willing to pay for it.”

I hate this crappy cliche for two reasons:

1. It ignores massive information asymmetries between buyers and sellers

2. Even if it was true, it is useless. I don’t know what to recommend you do with this information.

Let’s ask the oracle …

That’s better.

Uncle Warren is always on hand with something sensible.

But it still doesn’t help us measure it.

What about the textbooks?

The nerds have an answer for everything.

Well, there are endless variants of valuation methodologies. 300,000 word textbooks written on the topics. Every one I’ve ever read is frustratingly impractical (there’s a reason none of them have appeared in Book Club).

Science of valuation is often an exercise in being wrong in a great amount of detail.

So why bother?

Well, in order for M&A to happen, there needs to be an overlap in price between the buyer and seller.

A scientific approach helps bridge gaps between buyers and sellers.

It gives a common language, and helps deals get done.

The Three ‘scientific’ approaches to valuation

There are three main schools of valuation theory

a) Discounted Cashflow

This one is for the purists. The total of the future expected cashflows of a business discounted back to ‘today’s money’.

b) Multiples of a Metric

This starts with a metric that represents the future cash potential of the business. And then a multiple gets applied to it. That multiple is from a range justified by previous transactions (comparables).

c) Asset based valuations

Options a & b are both ‘earnings’ or ‘cashflow’ based valuation methods (in theory at least). This third school of valuation is valuing a business asset by asset. At it’s simplest, this means using the balance sheet value of the acquired assets / liabilities. In practice, this means applying some sort of realization % asset by asset. This is common in breakup or distress scenarios.

Understanding the deal perimeter

Making sure you are clear on what is ‘inside’ and ‘outside’ of the valuation perimeter is very important. Particularly so if you are acquiring a business that is being carved out from a corporate.

Think of it like buying a car. Part of deciding what you pay is understanding whats included. How long is the warranty? Is a service pack included? Is the fuel tank full or empty? Etc.

Look for trapped value

Sometimes when you buy a business, there is something in the ‘parts’ that is more valuable than the ‘whole.’

Let's revisit the example in the introduction to this series. There was a value arbitrage by closing the loss making operations. The residual business was then far more valuable than the initial transaction as a whole.

This can mean writing different valuation methodologies on different part of the business.

Going back to the example I gave. In practice, we ascribed an ‘asset based valuation’ to the three loss making sites; the value of the real estate minus the costs to close the operations. We then ascribed an earnings based valuation to the profitable part of the business.

The seller was not prepared to do the same work and missed the opportunity. They wanted this $10m ‘bleeder’ off their balance sheet.

By paying $47m we both accelerated their cash realization, and saved them a bunch of work. It was a small non-core business for them, they wanted it gone. Meanwhile, we had just acquired something for $47m we had valued at $190m on a base case.

Discounted Cash Flow (DCF)

I will assume you understand the basics of discounted cashflow. If not, google it, there are plenty of great explanations of how it works.

If the definition of the value of an asset is the ‘present value of its future cashflows’ then DCF is the purest possible calculation of that.

It’s technically robust. Technically perfect even.

Here’s the problem

DCFs are built entirely on forecasted assumptions.

Forecasts are b*ll shit.

You know it, and I know it.

Especially long range forecasts.

Especially long range forecasts for a business you don’t understand.

Especially long range forecasts for a business you don’t understand, where the seller (providing information) is actively trying to get you to overpay.

Let’s use an example to define the problem with using DCF to generate a valuation.

Imagine a business with $500 free cash flow. Expected to grow at 8% per year using a discount rate of 10%.

DCF of $23,310.

Now lets use exactly the same working, but assuming a growth rate of 7% per year, and a discount rate of 11%. All other assumptions are the same:

DCF of $11,819.

We tweaked two assumptions by a single percentage point, and it cut the valuation in half.

There is no perfect science behind estimating a growth rate, or a discount rate. An error rate of 1 percentage point or more is an inevitability.

And we haven’t even talked about the assumptions and complexity behind a free cash flow forecast.

DCF is technically perfect, but not very useful in practice.

There is one way I like to use DCF, which we’ll come back to down the page.

Comparable transactions light the path

If DCF is the theory, comparables or multiples are the practical antidote.

But multiples of what?

Most common is an EBITDA multiple.

And there is good logic to this. Especially for businesses with low / no capex. Remember we are valuing the ‘enterprise’ excluding any debt or capital structure considerations. We are addressing those separately through the bridge to equity value. So using a cashflow measure that is before any interest cashflows (or associated tax shield) makes a bunch of sense.

The challenge comes in ‘normalizing’ EBITDA to an underlying position. This is where ‘adjusted’ or ‘proforma’ EBITDA comes into play. I.e. a Letter of Intent might agree a multiple of 10x ‘adjusted’ EBITDA. The due diligence process then becomes a debate about what that adjusted EBITDA is. Week 5 on Quality of Earnings will cover this topic in detail.

So how do you set that multiple?

This is where comparable transactions come in.

Previous similar transactions are the best guide for the appropriate multiple. They help set a lower band, upper band, and median.

Then use your qualitative understanding of the business, the market and its potential to find an appropriate point in the range.

Ultimately, it’s about the risk of EBITDA falling, or the potential for it to rise vs the comparable set.

What about businesses with capex?

In industries that have high capex needs, EBITDA multiples fall down.

They are still used as the standard by investment bankers for comparable transactions. Even in those high capex industries.

I find this frustrating. It’s wrong, and easy to fix.

Imagine two businesses both with an EBITDA of $50m.

One has annual recurring capex requirements of $5m, the other $25m.

EBITDA comps would value these businesses the same (assuming all other things equal). That is a nonsense.

The fix is simple. Calculate the comparables analysis on a multiple of EBITDA less expected recurring annual capital need.

This is a much closer proxy to underlying cashflow. A much more appropriate basis for valuation.

What about multiples for businesses with negative EBITDA?

This is where revenue based multiples come in.

Revenue based multiple valuation are ok if the person using them understands the underlying unit economics. And the potential for that revenue to convert to profit in the future.

But they need to be used with extreme caution. Revenue multiples get used to justify all manner of sins. And in doing so drive a poor ‘growth at all costs’ culture in businesses that don't deserve that mandate.

Some businesses deserve this sort of rocket fuel. And can be valued on a revenue or user based metric

But most business don’t.

The great VC investors are the ones who understand the difference.

Comparables have gone stale in the last 18 months

There is a problem with comparables. The assumed multiples need adjusting for different economic conditions.

Almost every transaction conducted over the last fifteen years has happened in a zero interest rate world.

Low interest rates = lower investor return expectation = lower discount rate = higher discounted cash flow = higher valuations.

The rules have changed in the last 18 months.

Interest rates are higher, meaning investors need more return to justify the risk. They can now buy treasuries for 5% yield. So need a premium to justify owning ‘risk on’ assets.

Owners of assets aren’t yet (in the main) recognizing this new reality, so aren’t selling.

The result?

There isn’t a lot of valuation overlap, and not much M&A is happening.

This demonstrates the inverse relationship between discount rates and multiples.

It’s also where the theory becomes important again. We are reliant on it to help reset the market.

An interesting time for M&A.

Asset based valuations

An asset based valuation is an alternative to valuing on cashflow and earnings.

This means valuing each component asset separately. Then the valuation of the total is the sum of that asset based valuation.

This is very common in liquidation scenarios, where a cents:$ gets agreed on each individual asset. That markdown will be based upon the likely cash realization of those assets.

An example: Cash could be marked at 100% book value. Receivables at 80%. Inventory at 50%.

But insolvency is not the only scenario where this method works.

Replacement cost is another valuation method. It can be a useful way of triangulating back to an earnings based valuation.

I.e. what would it cost someone to build the assets from scratch to produce the same business and earnings flow.

In theory, any rational buyer would not pay a large premium to replacement cost value. They could simply replicate the assets themselves.

The role of real estate in a transaction is important here too.

Commercial real estate is often valued on a ‘cap rate’. The value gets backsolved using a market yield.

In a transaction where a business and the freehold real estate is for sale, it is common to value the ‘operating business’ and ‘real estate’ separately:

This is done by adjusting the EBITDA to assume a market rental charge for use of the property. The cost of use of the real estate gets built into EBITDA. Like this:

The best deals I have seen, use some combination of earnings based and asset valuations. Including the example earlier with the three loss making operations.

They understood where the valuation dynamics where. Defined them properly. Then valued the individual component using the method that made sense for that component.

Not all synergies are born equal

Now a word on synergies.

Often the core of the rationale for a transaction.

The magic that creates the overlap in value between buyers and sellers. (There’s plenty more time for synergies as we go through this series)

Distinguish between hard synergies, and soft synergies.

Hard synergies; synergies that can be quantified now to a reasonable level of accuracy. This means a high degree of executional certainty. Measured in extra annual EBIT contribution.

Soft synergies; nice ideas that might make us some more money in the future.

Hard synergies = more certain. Duplicate management. Procurement scale benefits. Fixed cost duplication. These all can be easily valued, and good operators will deliver them.

Soft synergies = cross selling, pricing or volume increases, almost anything revenue line.

The distinction is important, because hard synergies can be built into valuation math, but soft synergies must not be.

Ideally you don’t pay the seller for synergies, those benefits all accrue to the buyer. But in practice, in competitive deals you may have to share some of the hard synergy value with the seller. At least if you want to win the auction you might.

BUT you should never build any soft synergies into the price you pay, that’s a recipe for disaster.

The Power of Reverse DCF

Whilst I’m not a fan of DCF in practice. I do like reverse DCF as a triangulation point for a valuation.

What does that mean?

Let’s say we have used an earnings or asset based valuation method to value a business at $500m.

We can then use a DCF model to reverse engineer the assumptions that would need to be necessary to justify $500m.

Then by working back the implied growth rate and implied discount rate, you can then decide whether those assumptions feel comfortable or not.

It’s a nice checkpoint.

Just because that’s what it’s worth doesn’t mean that’s what you pay

Finally, remember that just because you value a business at X, that you should pay X to acquire it.

Price is what you pay, value is what you get.

Smart acquisitions are about making sure that gap is as big as possible.

We’ll talk more about this later in the series.

This was a long post, and I do want to round it off with something practical.

So these are the steps I use to valuing the business.

1. Understand the external perimeter of acquisition

2. Breakdown into individual cash generating units

   1. Individual operating units (loss makers vs profit makers)

   2. Treatment of real estate

   3. Etc

3. Value each of those units using either:

   1. Earnings based valuation: Multiples of Normalized EBITDA less Recurring Capex

      1. Estimate Normalized EBITDA (to be tested by DD)

      2. Estimate recurring capex (tested by DD)

      3. Decide on appropriate multiple

         1. Identify peer multiple range

         2. Use qualitative factors to decide correct point in range

   2. Asset based valuations

4. Aggregate to achieve a total enterprise value

5. Backtest the valuation using reverse DCF

6. Repeat steps 3, 4 & 5 but this time including hard synergies (that could be realized inside 12 months)

7. Decide how much of the synergy premium to include inside the valuation offer.

Anyway, those are my rambling thoughts on valuation.

The devil is in the detail, but the real value is found in deals where the price is so good, the detail doesn’t matter too much.

We will pick up the bridge from enterprise value to equity value later in the series.

Next time (after a short break) we will dive into the detail of how to build a deal team; who does what, and how to manage advisors.

THIS WEEK ON TWITTER

1.1m saw my Twitter thread on reading the balance sheet this week. Twitter is wild.

A masterclass in writing for impact from Steve Jobs:

Seriously now. Learn to write. It’s been a game changer for me. Not just online, but even more so in my day job.

I don’t mean how they taught you in school, that’s useless. Writing for impact. It’s different.

BOOK CLUB

Long before it was fashionable to talk about the creator economy, or personal brands, Daniel Priestley wrote Key Person of Influence.

This book talks about the value of being seen as a public figure of authority in your domain. And it gives a step by step guide on how to do it.

It was hugely influential for me and affected how I thought about my professional impact and persona. It was also the single biggest influence on me in starting the Secret CFO, and everything that has come from that.

Daniel is one of the best minds on entrepreneurship and the nature of work. Check out his podcast with Ali Abdaal if you want to hear him first hand. I think it’s my favorite ever single episode of any podcast.

FEEDBACK CORNER

A review of the last edition:

Good luck in the new role my friend. A Big 4 audit start, then lateral move into the FDD line of service, is a great start to your career. Do 2 years, then decide whether you want to be a partner or not. If so, head down, and go for it. If not, leave and join a great business in the FP&A team.

REFER A FRIEND, GET A GIFT

Please tell your finance fwends about this newsletter. I’m trying to build the biggest community of accounting and finance pros in the world, but I need your help to do that.

CASHFLOW TIP OF THE WEEK

Anyway …

That’s all for this week. As always you can find me here:

• CFO Secrets

• Twitter

• LinkedIn

• Threads

I’m taking a week off next week, to get the next 3 parts written. Then we will return on Saturday August 5th where we talk about the deal team, how to structure it, advisors and more.

Until next time…

Stay Crispy,

The Secret CFO

Disclaimer: I am not your accountant, tax advisor, lawyer, CFO, director or friend. Well, maybe I’m your friend, but I am not any of those other things. Everything I publish represents my opinions only, not advice. Running the finances for a company is serious business, and you should take the proper advice you need.