Myths and Facts of Valuations

Second in a two-part series

In Part 1, we addressed some myths about valuation and how the softening home building market affects valuations. In this article, we outline the methodologies we use in valuing companies, answering the recurrent question, "What is my company worth?"

Methods for Evaluating a Company's Worth

We begin with a number of tried and true methods. It is important to remember that a buyer who invests cash in a company is looking for a cash return on that investment sooner rather than later. We therefore look to future earnings as a proxy for cash when using the following methodologies.

Multiple of Forward After-Tax Income:

This method multiplies the pro-forma after-tax income by the appropriate multiple to calculate the value of the company's equity. Multiples rise and fall as the home-building sector becomes a more or less attractive investment opportunity, which can have considerable impact on valuations. Recently, multiples have fallen as the sector has fallen out of favor.

Multiple of Forward EBITDA:

EBITDA — Earnings Before Interest, Taxes, Depreciation and Amortization — times the appropriate multiple gives the value of the entire firm, both debt and equity. It is especially useful because it eliminates the cost of borrowing and allows for comparisons across firms with different capital structures.

Sum of the Parts Method:

This approach assumes a buyer will pay market value for all the assets, assume all the liabilities and pay a franchise value for the market position. Due to soft market conditions, we analyze the work in process and land/lot inventory for possible slippage in values. This method is particularly useful if the company has land with significant value over cost or excess profits in its backlog.

Return on Inventory Method:

Most buyers are looking for a return on inventory of at least 20-25 percent that can be calculated by dividing EBITDA by average inventory for the period being measured. Companies with higher earnings and lower inventory are more efficient and worth more than less-efficient companies.

A Balanced Approach

As stated in the previous article, Multiple of Book Value is not a valuation methodology but a reference point. A much preferred methodology is DCF, the discounting of future cash flows at the appropriate cost of capital. Although the most accurate, it can be the most challenging given the difficulty of forecasting many years ahead.

No one approach gives an exact valuation result. Future projections are estimates; franchise value can be subjective and multiples change over time. Factors including management strength and market share affect the final valuation, as do the effects of purchase accounting. An accurate valuation weighs both the objective calculations with the more subjective factors.

Final Thoughts:

An owner's emotional attachment for his company can cloud his perception of its value. The right methodology brings objectivism, experience and conservatism to the process, through a focus on producing realistic, achievable projections, testing the assumptions by analyzing the backlog, and gaining a thorough understanding of the company and the market during the process. While an imperfect science, valuations can serve a vitally important role in financial planning and merger and acquisition transactions.

David Rosen prepares valuation reports for Michael P. Kahn and Associates clients, analyzes financial data, creates the financial presentation, and supports all facets of the transactions.