Dave Cain: Welcome to unsuitable on Rea Radio. The award-winning financial services and business advisory podcast that challenges your old-school business practices and the traditional business suit culture. Our guests are industry professionals and experts who will challenge you to think beyond the suit and tie while offering you meaningful, modern solutions to help you enhance your company’s growth. I’m your host, Dave Cain.
If you own a business, you probably spend a lot of time thinking about the day-to-day management. Unfortunately, the only thing that does is help you to maintain the status quo. After all, as we said before successful business ownership is so much more than the daily grind. You need to have a good idea of what the big picture looks like or rather what you want it to look like.
I’m happy to welcome Tim McDaniel back to unsuitable. As a principal and director of the firm’s business valuation practice, Tim works with business owners who are ready to dig themselves out of the trenches and focus on business growth. Today he’s going to explain the three primary factors or the three-legged stool while you attempt to embark on strategy to increase the overall value of your company. Welcome back unsuitable, Tim.
Tim McDaniel: Well thank you, Dave. I appreciate it.
Dave: Good, so I understand we’re going to talk about a little valuation today.
Tim: We are.
Dave: Let’s set the table a little bit. In your career, give me an estimate of how many business valuations you have done?
Tim: Sure, but first you have that nice American flag there. I really like that. It matched that Speedo you had last year.
Dave: I’m just trying to stay current.
Tim: It’s taken me some counseling to get through that.
Dave: Yes, okay.
Tim: I just wanted to let you.
Dave: What the flag or the Speedo?
Tim: The Speedo.
Dave: We’re going to have matching race Speedos for the swim team.
Tim: Well, good. I need to some more sit ups.
Dave: Yes. Let’s get back on target. Thanks for that call out, but how many business valuations have you done over the years?
Tim: About 2500.
Dave: 2500.
Tim: Yes.
Dave: Apparently, you have a little bit of knowledge in this area.
Tim: A little bit, yes.
Dave: As we start down the stage here, the metrics of business have changed since you and I started in this business. It use to be the old here’s the financial statement, here’s the tax return, here’s maybe a budget and a projection. Now we’re seeing business owners and I think you see it relying on these business valuation reports, these specialty reports.
Tim: Yeah. What I have found is that many business owners set their value based upon their retirement needs or their ego or something like that, not based upon real facts.
Dave: I think you’ve shared with me the person who has the least knowledge of what the value is of their business is sometimes the business owner.
Tim: Sometimes. There are some that are pretty good. I always have a fun game after I’m done with an evaluation, I ask them what they thought the value should be or what they thought the value was going to be and how it compared. There’s maybe 10-15% of the time they’re right on button and a lot of times they’re way off.
Dave: Was it Johnny Carson that Ed McMahon did the Karnak? What’s your business worth?
Tim: Oh yeah.
Dave: You remember that?
Tim: I’ll start doing that.
Dave: You should start doing that. As you put emphasis on the valuation, is there a place you start? You talk about the three-legged stool. Is it cash flow, sustainable cash flow?
Tim: Yes. I think that’s the most important thing. Just let me explain that, what is sustainable cash flow. That’s the amount of cash that I can put in my pocket after I buy your business and I can go out there and spend whatever I want. Basically, what we’re trying to do is we’re valuing the cash flow that is available after you make working capital additions, after you buy your capital expenditures, and those type of things, you pay yourself a normal salary. This is what’s available for you to do what the heck you want with.
Dave: You use the term sustainable. Is that one-year cash flow, two-year, three-year? What does that mean?
Tim: That’s a great question. What we’re trying to do is look in the future. This is a great example. A couple days ago we had something that happen. The United airlines where somebody was pulled out of their seat and it’s been national news. It’s crazy. What did the stock do? It plummeted. Why? Because the investors feel like the future sustainable cash flow of United is going to go down, that people are going to buy less tickets. It’s going to have less profits, therefore the valuation goes down. We’re always trying to look into the future. A lot of times the past is a good indication of the future, but we want to know how much of that cash flow could I put in my pocket year after year if I buy that business. That’s how we try to approach our evaluation.
Dave: Based on your last comment, we just lost United as a sponsor for Rea Radio.
Tim: Well, that might be good.
Dave: But we picked up Speedo as a sponsor, so we’re good to go.
Tim: Okay. Good.
Dave: We’re good to go. You always talk about rate of returns when you’re talking about valuation. Explain that to our audience about what a required rate of return or what are you looking for?
Tim: Right, so again I talk about the first leg of the stool as the sustainable cash flow. The rate return is how certain are you is that cash flow is going to continue in the future. For example, say Warren Buffett comes to you and says, “I want you give me some money,” this is Warren talking, “and I’m going to give you a certain percentage return every year. I’m going to personally guarantee it.” Well, you might just say, “In today’s economy, I might do 3 or 4%. That’s pretty good.” Now if they come to me and say the same thing. They can say, “Well Tim, we may want 20%.” If they went to you, they may want 50% in a rate of return. It’s sort of a based upon certainty. The rate of return varies. For most businesses, it’s somewhere between 12 to 25% of all these valuations that I’ve done.
Why would it be a 25% versus 12% and the higher the rate of return, the lower the value? Well, things like customer concentration. If you have 60% of your business with one customer, how certain is that future cash flow going to continue? How do you feel as a buyer? If you drive all the sales, you have all the knowledge of the product in your head, you have a very thin management team, what does that do to the rate return? If your product is going to become obsolete pretty soon because there’s a new invention, those are the type of things we look at when we do evaluation.
Dave: Let me throw an example at you. I’ll change the names to protect the innocent, but let’s say my business is 60% concentration in the automotive industry and we’re just knocking it down. Cash flow, profitability, valuation through the roof, but I think I heard you say because of that concentration my value may be downgraded a bit.
Tim: Yeah, now it depends. If you’re in a specific industry, maybe not as much, but if it’s one customer, it would be downgraded.
Dave: So more customer concentration?
Tim: Right.
Dave: If all my business was with United or Speedo, we might have a discount on the value.
Tim: Right. Say you had a security firm that did the thing at United and United was their biggest customer. What do you think the value of that company has done?
Dave: Well-stated, well-stated. Annual growth rate, we always talk about that and I hear your team talk about the annual growth rate. What does that mean to me?
Tim: Sure. Well, you know that a lot of the listeners probably follow the stock market. You see a company like Facebook, which has maybe a 50, 60, 70 P/E ratio compared to Ford that might have a 10% P/E ratio. What’s the difference? We’re all valuing future cash flow stream, but the difference is the company with the higher price earnings ratio has a higher growth rate. Buyers are buying future growth. Growth has a big impact on future evaluation, the valuation of your company.
Dave: You’ve mentioned to us three areas, sustainable future cash flow, required rate of return to invest, and annual growth rate. Those are your three legs of the stool.
Tim: Right.
Dave: What happens if I get two out of three right? My stool is tipping over I think.
Tim: Your stool is tipping over. Now if you have a really great cash flow, low risk business, you’re going to have a nicely valued company. Growth does help that value, but if you have those two factors, those are the two most important factors in my opinion. You’re right. It’s incredible. Actually, I gave a seminar yesterday and I went through an example. Say if one company makes $1.5 million sustainable cash flow and their rate return is 25% for this company. That’s a value of about $2 million. I just said, “Let’s just double the sustainable cash flow, cut the rate in half.” My cash flow is a $1 million, the rate is 12.5%, that value goes to $8 million. Incredible. It went from $2 million to $8 million by focusing on higher cash flow and lowering your rate of return.
Dave: This three-legged stool basically is an equation that must be balanced. One might be higher than the other but it is an equation. It’s a balancing act.
Tim: Right. It is a balancing act. I really recommend that business owners start slowly. Let’s come up with a plan to increase your cash flow. Come up with a plan to decrease your risk. Those are the first two things I would focus on then focus on growth.
Dave: I should have mentioned this in the intro, but you recently authored a couple books about know the value of your company and then grow the value of the company. You do offer a consulting service in that area. If I came to you and said, “Look, my stool is tipping. I want to work on my sustainable future cash flow.” That would be something you could help me as a business owner increase that part of the equation.
Tim: Absolutely, the first thing we would do is compare you to other people in your industry. Let’s see what your gross profit is compared to others in the industry. Let’s take a look at your operating expenses. Let’s look over your working capital issues. Can you improve your working capital cash flow and start there.
Dave: I’m impatient I want this business to grow. I want the value going up. It’s my largest asset on my balance sheet. I want to go, but I guess how patient should I be?
Tim: Well, I have not seen anybody really turn around a business in 30 days, 60 days, or something like that. I think it’s why it’s really important to really start this process before you’re ready to exit. Maybe it might take you five years to get your company really humming, to have the three-legged stool well-balanced, but if you start today, you could probably double or triple to your value of your business.
Dave: Really the key is start early before you’re ready, just like starting for retirement. If you start valuing your business at age 65 and improving it, it might be a little bit too late.
Tim: Right. I like what you said earlier. It is the biggest asset for most business owners. It’s probably 60, 70% of their net worth. They spend a lot of time with investment advisor, which they should, trying to grow their 20 or 30% of their 401(k), but if they really focus on trying to grow the value of their business, that will have a bigger impact on their future than growing their 401(k).
Dave: You mentioned the valuations and updates and of course with 2500 under your belt that’s a pretty good history, the experience you have is phenomenal, and I want to rely on that experience for this next question. How often should I have a valuation? I’ve asked you that before. I get a tax return every year and I do my personal financial statement every year and this and that, but how often should I have that valuation?
Tim: I think it’s a good question. I mean there’s some businesses that are early in the process, the owner is fairly young. You maybe a baseline valuation and maybe do another one in five years and see where you’ve gone. But I think if you are starting to think about succession planning, exiting, I would recommend in doing it for every other year. Particularly if you have more than one shareholder because you should base your buy/sell agreement based upon an updated valuation, not based upon some stupid formula or some other provision that I see in buy/sell agreement. I’d say about 80% of buy/sells that I read are not effective on the valuation side.
Dave: You’ve hit a nerve there. I think we both have seen buy/sell agreements that have been poorly authored and at the end of the day is a bad outcome.
Tim: Right. Absolutely.
Dave: To our listening audience, pull that buy/sell agreement out, take a look and if there’s a formula or whatever … What would you recommend they do with that buy/sell? What do you look at first?
Tim: Well, I would say all formulas are dumb in a buy/sell agreement. I mean you say, “Four or five times earnings.” What is earnings? Some business owners take out a $1 million salary, some take out $1, so the earnings goes up and down. That little formula doesn’t include balance sheet issues. Whether you a million dollars of debt or a million dollars in cash. How do you factor that in there of one multiple?
I really recommend is the shareholders get into together get an evaluation and they name what the value is going to be in the buy/sell. If something triggers the buy/sell, this is what the value is going to be for the next year. Then they get together every year and update that value. Maybe they need somebody like me come in every other year to help them with their guidance.
Dave: We also see the terminology EBITDA in some of these documents and again that’s confusing to a lot of people, myself included. To me, sometimes that’s a fancy word for dressing up earnings that aren’t really attractive.
Tim: Well, EBITDA could stand for earnings before a trip to dumb otto.
Dave: That could be too. I never thought of it that way.
Tim: Okay, yeah.
Dave: As we go through the buy/sell as you can continue to go through that, would you look at that buy/sell agreement again for not formulas but methodology?
Tim: Yeah. Again, I think the best methodology is the name the value. If you don’t want to do that, then maybe you have a valuation provision in there where you hire a professional valuator to do the valuation but just don’t have a formula in there.
Dave: I hear you said start young. It’s kind of like saving for college. If you start right when that kid is born, it will grow, it will compound. If you start that valuation thought of growing the business at an early age, it will pay big dividends.
Tim: Yes, sort of like Franklin Covey said, “Begin with the end in mind.” I think it’s very good advice. What do you want to do for your business? When you’re ready to exit, how do you want to exit? Is it an ESOP? Is it a buy out? Is it a gift? All of those have significantly different strategies as far as to make those really really effective.
Dave: Going back to your stool example with the future cash flow, rate of return, and annual growth rate, I also heard you mention the term risk, but I don’t see risk in this equation but that plays a big part I’m sure.
Tim: That’s part of the rate of return. The more risk, the higher rate of return you’re required to invest in something.
Dave: It’s embedded in the required rate of return.
Tim: Right.
Dave: Can you share a couple of examples that you’ve run into over the last several years of a risk factor that’s driven down the required rate of return.
Tim: Well, actually the risk factor increases the rate of return. A real-life example would be any business that maybe has over 50% with one customer. I’ve seen that and I’ve seen that one major customer leave and a company go bankrupt. I’ve also seen there are ways to mitigate it. Maybe you’re a business owner, you have a large customer, you can’t get other customers but maybe you can sign them to a five-year contract. That gives you a little less risk because you feel better that that cash flow will be there.
Dave: Major customers, again, there’s the good and the bad. We all love major customers, but inside there, there’s a tremendous risk.
Tim: There is, yes.
Dave: Lately with the new administration in the White House, what’s the impact … I mean do you feel, do you see, do you sense that that has an impact on business valuations?
Tim: That’s a great question because I ask every business owner, which has probably been about 20 or so since the election after I get done with the valuation or during the process, how does this new administration impact value? It’s funny, there’s not a consensus out there. I think people are feeling a little more comfortable that there’s not going to be major changes. They’re hoping for lower taxes and maybe that increases cash flow. There seems to be a little more confidence out there, but I wouldn’t say there’s a material difference right now.
Dave: Really, kind of a neutral impact but it’s out there. There’s some thought going on. I think we might have touched on this a little bit, but the annual growth rate, again, can you put your finger on some examples of a growth rate that you’ve used? I know you mentioned that earlier on, but I just want to reemphasize what an annual growth rate you would look for.
Tim: Well, this is a mistake I see in a lot of valuations. Some valuators will say, “A company will growth 10% annually for infinity.” You do the math and they’re going to be bigger than Microsoft in 40, 50 years or so.
Dave: There goes Microsoft as a sponsor also. We’re just losing track of you all.
Tim: A sustainable growth rate typically is a little bit higher than the G&P growth rate, but if we know that the growth is going to be really high over the next few years when we are doing a valuation, then we do something called the discounted cash flow method where we actually forecast the future until it gets to a flat growth rate and then we calculate the value that way.
Dave: Our guest today has been Tim McDaniel, the lead principle and director of the Rea business valuation practice, located in Dublin, Ohio. Tim works with various business owners throughout the country actually to improve the value and know and grow the value of their business. Tim, thanks so much for sharing your insight with us. We do have to have a couple little questions here before we wrap up. I know you’re a football fan. This podcast will be released after the NFL draft. Who do you see the Brown’s drafting?
Tim: That changes daily. I thought up to a week ago Miles Garrett was the consensus. I still think that’s what they should do. I don’t see any quarterbacks that would grab with that number one pick.
Dave: Brown’s going defense. Are the Cavs going to go make it to the finals?
Tim: Yes.
Dave: The Indians to the World Series?
Tim: Absolutely.
Dave: There you go.
Tim: There’s the three-legged stool.
Dave: That’s it, perfect. Good way to wrap that up. Thanks again for joining us on unsuitable, Tim. A big thank you to our listeners for tuning in. Be sure to check out our website at www.reacpa.podcast for a wealth of information on this subject and don’t forget to subscribe to our podcast on iTunes and never miss an episode of unsuitable again. Until next time, I’m Dave Cain encouraging you to loosen up your tie and think outside the box.