Saturday, October 31, 2009

Valuations and depreciation

Ask a business broker to place a value on your business and 99% of them will exclude depreciation and interest expenses from net operating expenses, and as a consequence they will often arrive at a significantly higher valuation than what Larry Hunt and I would arrive at using our business valuation methods.

Why? Because we view depreciation as a real expense to be considered, not a purely hypothetical $$$ amount that can be casually added back to net profits and translated into an increased valuation of the business. Why do brokers do this? First, it often leads to a higher valuation and a higher valuation always pleases the seller and brokers almost always represent the seller.

If you purchase a $100,000 piece of equipment and depreciate it over five years (straight line) then your Profit and Loss statement will report a depreciation expense of $20,000 each year. Most brokers will add that $20,000 back to cash flow when attempting a valuation. We, on the other hand, will treat it as a legitimate expense, even though a check was never written in that year.

On the other hand, suppose at the end of the year you decide the purchase was a terrible idea and you call the dealer or run an ad in a trade magazine. What do you think that piece of equipment will sell for at the end of the year? Do you think you can recover 80% or $80,000? Chances are good that you will be very lucky to recover even $80,000. Most likely you will be offered less. Whatever the offer, I think we most of us can agree that we will get significantly less than we paid for it and it is the difference between selling price and current value that depreciation is supposed to represent. When you sell an asset for less than you paid for it that is depreciation and that is exactly what you end up doing when you sell the business... you end up selling earnings potential and the assets used to produce those earnings.

What happens if you depreciate that piece of equipment over a five-year period of time. What do your financial statements look like in the sixth year? Well, assuming that piece of equipment was the only purchase in the past five years, your financial statements are no longer reporting a depreiation expense and your balance sheet shows an asset value of $0! In "Print Shop for Sale" we would assign a real-world, market value to that asset since it no doubt has some residual value while at the same time continuing to produce earnings for the company.

More on this topic later.



Anonymous Martin Schultz said...

You appear to be making the case for valuations to be based on earnings and not cash flow or ebitda. Doesn't that depend largely on the practice in a particular industry. However you also seem to be making the argument that there needs to be some consistency so people can use valuations to compare alternative investments. You are dead on there.

November 1, 2009 at 7:44 PM  

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