Enterprise Value Calculation: Part 1 Stand-Alone

The first part of the formula determines a range of enterprise value based on the company being purchased as a stand-alone or platform. This part takes into account the following current characteristics of a seller:

1. Sales Size
2. Organic Growth
3. Restated EBITDA Margins as a percentage of sales
4. Averaging sales and margins to determine trends over a number of years
5. Additional Factors
6. Balance Sheet Data

1. Sales Size

The toughest thing about success is that you've got to keep on being a success. Talent is only a starting point in business. You've got to keep working that talent. - Irving Berlin

Many companies, when they are first starting, are small and do not face overwhelming national competition. Rather, they are focused on a very small niche and fly under the radar of tough competition. However, as companies increase in sales size and enter new territories, they start to gain the attention of competitors and begin to experience increased competition. How a company survives and grows when confronting these obstacles, without making acquisitions, determines how sound its internal business model is. The better a company's performance with its business model, the higher the purchase price the sellers can expect to receive. The worse the performance, the poorer the business model, the lower the price they can expect to receive.

Buyers of companies, whether strategic or financial, generally need to perceive that a seller's business model is viable for at least 10 years. The reason that a 10-year time frame is important is that strategic buyers focus on their strategic plans for 10 years and want to make sure that the seller's company will continue to add value to the new parent over this time period. A financial buyer usually owns a company for three to seven years before the buyer may seek to sell it to the next or second buyer. The second buyer (who is purchasing the company from the first) must be able to see an exit for their purchase/investment as well. If the second buyer cannot see a lucrative exit, then they will obviously not be willing to pay a high price to the first buyer for the company. The larger a seller's company, the more strongly the first buyer will believe that the company is a long-term survivor. The more certain the first buyer is that the seller's company will continue to survive and be profitable, the more money the first buyer will be willing to commit to the deal. The smaller the company, the greater the risk of its not being a long-term survivor and, therefore, the less the amount of money the buyer will be willing to put at risk in the deal. This translates into a lower purchase price. Therefore, the larger the company, the higher the starting multiple of restated EBITDA the seller can expect to receive.

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2. Organic Growth

The longer the seller's trend lines are up for both sales and earnings without acquisitions, the more strongly a buyer will believe that both will continue. If the buyer is convinced that this growth will continue under new ownership, then the buyer will also believe that the company will be more valuable when sold to the next buyer. This belief should translate into the buyer being willing to pay a greater price for a company when they buy it. Conversely, should the trend lines be flat or down, the lower the price or value of the company will be for the buyer.

It is not the going out of the port, but the coming in, that determines the success of the voyage. - Henry Ward Beecher

When a seller has grown largely by internal or organic means, it is fairly straightforward to calculate a stand-alone enterprise value. However, if acquisitions have fueled its growth, the valuation is trickier. This is because acquisitions are an outside stimulant and, unless the industry is highly fragmented, additional acquisitions may not necessarily be available to continuously provide growth. In this case, the sales contributed by acquisitions for the last three years should be subtracted from total sales before using the Internal Sales Growth matrix. To the extent possible-and this is why valuation is more art than science-the sales growth contributed by each acquisition during the last three years should be calculated separately and added to the overall number.

Use the [A] Chart below for 5 Year Average Internal Sales Growth Matrix

1. You will compute a company's sales growth per year (without the aid of any acquisitions) for each of the last three years, plus the current year, plus the projected growth for next year, and then divide by 5 to get the average growth of the five-year period.
2. After you compute the average growth percentage, go to the left column on the matrix and using the current year's sales figure for the company, move down the column to the row where the seller's sales size matches.
3. Once in the correct row, move to the right and use the seller's average growth percentage to select the box that contains the corresponding percentage.
4. From this box move to the bottom of that column to the row labeled "Multiple," where the number provided gives you the first multiple for the formula.

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3. Restated EBITDA Margins as a Percentage of Sales

Many sellers believe that their company is unique and has a special niche, but buyers determine whether a company is unique by the simple rule that a company that is special has substantial Restated EBITDA profit margins (defined below). Low Restated EBITDA profit margins in comparison to a company's industry standards, despite an owner's protest, indicate that the company is not that special or, worse, is having operating problems. Usually, the smaller the company, the easier it is to have higher margins because the company can "cherry pick" the really high-margin business, and go after the low-cost sales. In addition, the owner and the employees can wear multiple job hats, keeping employee costs and employee count low and overhead low. Finally, the Seller might be small and agile enough that it can avoid major competitors and price competition.

As a company's sales increase, it finds that in order to grow it may have to go after lower margin business; go after business further away from its factory (thereby increasing its shipping costs); layer in new staff to deal with an increasingly competitive and complex business environment; or it may have to lower its prices or increase its services to cope with increased competition in new markets. Therefore, a buyer looks to see if a seller can maintain or increase the Restated EBITDA margins as their sales increase. If margins increase, it indicates that the company has a strong business model and leads the buyer to think this may continue under new ownership. If margins decline as sales increase, this might lead the Buyer to feel that there is a cap on the realistic growth and profitability of the company, thereby placing a cap on its profits and reducing the price he might be willing to pay.

1. Good men are not cheap
2. Capital can do nothing without brains to direct it.
3. No general can fight his battles alone. He must depend upon his lieutenants, and his success depends upon his ability to secure the right man for the right place.
4. There is no such thing as luck.
5. Most men talk too much. Much of my success has been due to keeping my mouth shut.

- J. Ogden Armour

The definition for Restated EBITDA means operating income less Capital Expenditures (Cap X) for maintenance, but not for growth (which gets put back into earnings), less non-recurring income, less non-operating income (i.e. interest income), plus non-recurring losses, plus or minus for normalization of owner's compensation and benefits to equal a professional manager's.

Use the [B] Chart below for the Matrix of Restated EBITDA Margins Percentage to determine the next result.

1. Determine the company's Restated EBITDA Margins Percentage for the Trailing Twelve Months (TTM) or annualized for the current year by dividing Restated EBITDA by Sales.
2. Go to the left column and then using the current annual sales figure for the company move down the column until the seller's sales size fits.
3. Then moving from the left to the right in this row, use the company's Restated EBITDA Margin to select the correct box the company fits into.
4. From there, move to the bottom of that column and determine the second multiple.

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4. Determining Initial Enterprise Value by Averaging

Using the results from Charts A and B above, look at (C) below and add the two multiples [(A) First Multiple found in your calculation in Internal Sales Growth, and (B) the Second Multiple found in your calculation in Restated EBITDA Margins] and divide by 2 to get an average. This will give you an approximate Multiple for the Company's earnings. The next step (D) is to use this Multiple to multiply the Company's latest annualized Restated EBITDA to determine an approximate price point for the enterprise value of the Company. Then (E), the Seller's enterprise value range, is plus or minus 10% from this price point.

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5. Additional Factors

There are approximately 10 more additional factors that can further refine the valuation range and move it up or down by upwards of 25% or more but are beyond the scope of this do-it-yourself valuation. Please contact us for a discussion of these questions and how they can affect your valuation.

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6. Balance Sheet Data

Success in any enterprise requires the right producer, methods and men and each must complement the others. - Joseph Burger

A range for the total enterprise value is determined by both the above calculations, adjusted for the additional factors in #5. However, the purchase price or amount of money the owner actually receives can be increased or reduced by the following items on the balance sheet:

Increase in purchase price by the amount of:

1. Excess cash over the company's average annualized needs that an owner can retain after the sale.
2. Outside investments that an owner can retain, which are carried on the books, but are not needed for the on-going earnings stream of the company (i.e., stock, Treasuries, etc.).
3. Excess working capital that is over the trailing twelve-month average of working capital needs.
4. Excess assets that an owner can retain because they are not part of the business or necessary for the earning stream being sold by the owner (i.e. a closed facility or equipment that is yet to be sold).

Decrease in purchase price by the amount of:

1. Any interest-bearing debt for both short-term (including outstanding portions of working capital lines) and long-term debt.
2. Any unfunded legal liabilities.
3. Any unfunded EPA liabilities.
4. Any unfunded pension liabilities.

Now, take your price point as determined in instruction 4(D) above and add all your balance sheet positives then deduct all the balance sheet negatives and that will determine a realistic midpoint for a purchase price.

If you have any problems or questions about the usage of these formulas please contact us.

• Continue to Part II »
  (Valuations of potential synergies for add-on acquisitions)
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