Business Valuation: Understanding the Build Up Method
My name is Robert Bonavito, New Jersey Forensic Accountant. This video is part of a series of videos where I discuss forensic accounting topics for educational purposes only. If this was a litigated matter, I would take a different approach, have different conclusions based on different facts and circumstances.
Hi, my name is Robert A. Bonavito, New Jersey Forensic Accountant. This video is part of a series where we discuss topics that really interest me and hopefully you, concerning forensic accounting, business valuations, finance. I think these topics are pretty relevant especially if you have some financial issues you're concerned about.
Today, I'm going to talk about the build up method. And you're saying, "What is the build up method?" The build up method is a way to calculate what's called a discount rate and the reason we use a build up method is it's a sensible way to find this capitalization rate.
For example, if you try to find out...if you want to understand how much your business is worth or how much this company you're looking at is worth, what is typically done, you find a capitalization rate, you find a cash flow and you divide it into that and it will give you what the value is.
For example, if you have a cash flow of $15 and you find a capitalization rate of 15 percent and you simply divide the $15 by 0.15, you get $100. So that investment is worth $100 to you because you want a $15 return so you'd expect to pay $100 for that. The way we used the build up method is to compare to other investments.
For example, if I put money in the bank...or let's say, a 20 year bond. Right now, you'll probably get three and a half percent or 3% right now, it's changing daily. But you'll get three and a half percent. Well, three and a half percent is guaranteed by the U.S. government so that's what's called a risk free rate. If I'm trying to build up a capitalization rate for like a small privately held company, I'm gonna start with this discount rate at three and a half percent.
We also know that long term stocks have paid out about nine and a half percent, which is called the long term equity premium. If you subtract the three and a half percent from that, from the nine and a half percent, you get six. So we're building this up. That's why we call it the build up method. Once you have those two items, then it's a matter of trying to judge the risk involved in the small business.
Over the years, I always say...someone tells me the return you're gonna get on this investment is 10% or 30% or 5%. I say, "Well, what is the risk? I don't care about the return. I wanna know what the risk is," because if I'm gonna get 10% with low risk or 10% with high risk, I'm gonna take the low risk every time. And so we keep that in the back your mind when you're doing this build up method return, at what risk?
Also, when you're dealing with value, two key concepts are time and uncertainty, which is kind of the definition for risk. But when do business valuations and even damage reports, we spend a lot of time in quantifying and looking at the risk, time, uncertainty to get this last part of the build up method. So often I see people invest in small businesses and I'm looking at their returns. It's like 8%, 10%, 12%.
I'm saying, "You can get that in an ETF fund or an SNP, you can get those returns somewhere else. Why are you putting in a small business when you have all this risk? Okay. It doesn't make sense. But time in time out people do that and that's why we get involved in a lot of cases because they ultimately they end up losing their money.
Instead, if you use this build up method, you're not gonna accept 10% for that investment, you're gonna want 30% or maybe 35% for that investment because the risk is so substantial. They have one product, they don't have a deep management team. They don't have good infrastructure. There's all kinds of problems with that small business that you have to quantify. That's what we do, it's a good part of what we spend our time on.
So, if you're going...I mean, especially in this economy, a lot of people, they have a hard time finding a good job and they wanna start a business or they want to buy a franchise. I always say, "Listen, if you're gonna buy a franchise, sit down and see what that cash flow is gonna be. See if there's any net cash flow over after you take your salary out. Then figure out what kind of rate you would put in there, 15%, 20% return. You can find out what that franchise is worth," because remember, a lot of people like to go into a franchise because everything's turn-key. But you also have a silent partner, right, and who is that? The franchisor.
That's why this build up method, it's important for me. But it's also important for anybody looking to buy a business, looking to invest in the stock market, pretty much everybody. You can do these calculations and figure out what's the risk to me? If there's a lot of risk, I want a bigger return. You can just run the numbers.
Let me just give you a little bit example here, okay? If we have a small business, let's say it has excess cash flow of $1.5 million. What would it be worth? Well, if we use a 22% capitalization rate, it would be $6.8 million. What does that mean? If you brought me into do this, there's a lot of work involved in here.
But just to give you a taste of what happens here, once we came up with this value, I came up with the cash flows. I developed the cash discount rate, I would say, "Listen. I think that you should pay $6.8 million for the business." And you may say 22% is a lot of money and because people don't hear those rates often except some of these hedge fund guys and stuff like that.
Most people never deal with 22%, except maybe in the '80s when the rates went up that high. So, they're like, "What are you...22%. That's incredible. Even my credit card rates aren't even 22%." But remember, that 22% includes all the risk for this small business. Even though it's a substantial business, it's not like an Exxon or an AT&T and those type companies like AT&T is a four and a half percent dividend or something. Who do you think has deeper management, this company here or AT&T? So that risk...we have to look at.
When we do the build up method, the four methods, the four types of risk that I like to look for is maturity risk. How long before I get my money back?
Okay. Market risk, sometimes called systematic or undiversifiable risk, it's just risk that's out there. You'll see this, like people say, "Diversify your portfolio," and there's a problem in Mexico and everything goes down because it's not diversifiable. The truth is sometimes you can't diversify. Sometimes everything goes down, gold goes down. It makes no sense. Oil goes down, gold, everything goes down because there's a risk out there that we can't quantify, it's called market risk.
Then there's a specific company risk that I look at and that's because, small companies, especially sometimes they have one customer, they have one product, they have no management, you know, the managers are old. We look at that.
Then liquidity. How easy is it to get my money out? You know, we have a lot of small businesses where we wanna...one shareholder wants to get his money back. There's no ready market for that stock. It's not like you could pick up...you know, most of the stuff that you buy in the New York Stock Exchange or the NASDAQ, you pick up the phone, "Hey, sell it." You got the money within 2 minutes, a minute or 30 seconds. Small businesses, your money is there and you're not gonna get it back in a week or 2 weeks or sometimes years. So, that risk is in here too and that's why we have high rates when you're dealing with small businesses. You know? They can be 30, 40, sometimes 100, whatever. If you have something that's 100%, you probably don't wanna invest in that company.
But anyway, when you...this is another tool for you to put in your toolbox. If you're looking at investment or you're thinking of doing something, sit down and try to say, "How risky is this investment?" If you come up with, you only want 10%, say something's wrong because you can get 10% interest other places. There are other ways to get 10% earnings on your funds and build up the rate. For a small business, you want something substantial...even for these franchises, you want a higher rate, somewhere 18 to 30%. Usually somewhere in between there.
My name is Robert A. Bonavito, New Jersey Forensic Accountant. If you have any questions feel free to email me or give me a call.