The Concept of Value and Other Whimsical Things – Part 1
The concept of value is a topic for which many trees have given their all, yet there remains much confusion. First let’s rid ourselves of the fantasy that there really is some fixed, determined value for anything… there is no value god who magically comes along and determines the proper value for this and that… although some financial consultants will try to tell you (and sell you) something different ;-) Neither they, nor even I, have the keys to this secret vault of value.
Rather the concept of value is very fluid, influenced by many factors. In most situations diamonds have a much higher value than water… but if you are dying of thirst this value equation might just change dramatically. Although that is an extreme example, it makes the point that many factors determine the value of anything and these factors can change dramatically… often in a relatively short period of time.
The value of any financial asset is the sum of expected future cash flows discounted back to a present value. This is a relatively easy calculation for a pure financial asset, like a CD or bond or some such instrument… although it is still open to significant subjective inputs. What will be the expected inflation rate over the respective period of time? Government T-bills are often used as a proxy for this number. These are used since they are assumed to be risk-free… although as the recent financial melt down shows, even the concept of risk-free is more subjective than many had thought. And this aspect, the relative risk factor is the other part of the discount rate… discount rate = expected inflation rate plus a risk factor… i.e. if the expected inflation rate is 3% and the risk-factor is 5%, the discount rate is 8%. Using a relatively simple formula, you use this discount rate to determine the present value of these future cash flows… the process is kind of like calculating reverse inflation.
But alas, again there is no risk god who magically determines the correct risk factor… and differences in this risk factor will have a significant impact on the present value of these cash flows. And using this same process for non-pure financial assets, you usually must also determine a terminal value. Conceptually these future cash flows go on in perpetuity but rather than attempting to calculate future cash flows years and years out, some terminal value is place on the asset and this value is discounted back to a present value. Of course what this terminal value should be is also open to considerable flexibility.
There are of course other proxies for discounted cash flow… but fundamentally they all are based on the same premise… that the economic value is based on discounted cash flows… kind of even makes sense if you think about it.
Some of these proxies might be some multiple of gross profit dollars, i.e. this is worth 4.2 times trailing 12 months gross profit. The advantage of this proxy is that the multiple is easily transferred from one distributor to another… you all have gross profit dollars and multiplying it by some number isn’t too dang tough ;-) That’s the reason I like it. This proxy is good for just general conversation (is it a “high” deal or a “low deal) and for sellers. Sellers don’t give a hoot about how the buyer is going to make it work, as long as they get their money. Buyers on the other hand have to make certain the deal actually works in the real world and thus they might make offers of X time 12 months gross profit, but that’s not how they arrived at the value.
EBITDA (earnings before interest, taxes, depreciation, and amortization) is also used to measure worth. This proxy is commonly used to compare profitability between companies and industries because it eliminates the effects of financing and accounting decisions. But there is no absolute standard on what items companies can include in EBITDA, thus it is not completely transferable from one company to the next, or even for the same company from one financial period to the next.
As many finance wizards will warn, EBITDA does not represent cash earnings… it is a tool to measure profitability, but not cash flow. EBITDA ignores the cash required to fund working capital and the replacement of capital equipment… and in distributorships these may or may not be significant. But this method is still a useful proxy for value, as in it is worth 14 times EBITDA.
EBIT (earnings before interest and taxes, also called operating profit) is also used. It too eliminates the effects of financing and accounting decisions but includes the non-cash items of depreciation and amortization. There are many other EB…’s that can also be used, each with its own strengths and weaknesses.
You could even just look at payback period… i.e. how long will it be before I get my dang money back? This of course ignores the time value of money and the timing of “getting my money back”. It makes a big difference if you get 90% of your money back from an investment in the first year… or if you get 90% of your money back in year 15. But it is sometimes useful to think in a payback period fashion, but only for broad brush stroke type discussions.
Heck, some folks even talk value as X dollars per case. But again, this might work from a seller’s perspective, but the buyer needs to build the operational and financial model prior to “backing into” a number like this. Regardless of how you choose to look at it, the value of a financial asset is still going to be determined by future cash flows discounted back to a present value.
But of course this is only the beginning. There are many other factors which influence value. My vision of the future and yours might be very different. I might forecast tremendous population growth, you a flat market. I might envision margins going up, you see them falling rapidly. I might envision a strengthening of my state’s franchise laws, you might see them crumbling in the next few years. I might expect market share growth, you a shrinking market share. In fact we might disagree on every internal and external factor which can influence a distributorship in a respective territory. This will have a tremendous impact on the value we assign to this distributor and its distribution rights.
And of course distributorships are not just financial assets, they are much more than that. But since I have been told repeatedly that I am long-winded (and this from friends!), you’ll have to wait for the next post to read more on non-financial aspects of distributor value.