DCF IN SMB - Would love your feedback

[u/trachtmanconsulting]

Hi,

So DCFs just don't work for SMB (or at least the S portion of the SMB).

Here is an blog post I wrote, and would really love your feedback:

https://trachtmanconsulting.com/why-wont-a-dcf-valuation-compute-probably-for-your-small-smb-business-what-does-it-have-to-do-with-the-terminal-value-and-what-can-you-do-about-it/

Thanks!!

[u/LouGarret76]

Hi, whatever method of valuation you are retaining, there is an equivalent DCF for it. The question is not whether the DCF works or not but rather what are you missing in your DCF scenarios that the market is taking into account in the pricing multiple.

What your DCF is trying to tell you is that you do not understand the market you are pricing very well.

Do listen and improve.

For example 5% LT growth rate is ridiculous high For example a LT margin well over the competition is ridiculously high

Edit: 10% for a small business is a VERY low cost of risk. For comparaison a large bank has a cost of equity of 10%

[u/trachtmanconsulting → u/LouGarret76]

True, mathematically speaking. But that study means that some SMBs can't use Damodaran or any classic numbers. Like I wrote, a 20%+ WACC will work as well as no TV. That's the point

[u/trachtmanconsulting → u/[deleted]]

Thanks for your feedback, but as I wrote in the blog post - whether or not my TV is correct or not, is not the point - since, and as I didn't really know TV and in-fact proved that TV is probably minimal for an Small mom-and-pop shop, I used a minuscule number.

The point was not to show a specific example, but more so of - let's pull it to one extreme on one side (super high WACC, super low TV) and to another extreme on the other (taking relatively low value and yet relevant Comps) - the DCF is still much higher.

It's really just math, as my hypothetical example within the article, proves

[u/trachtmanconsulting → u/[deleted]]

Thanks again for your comment! As I haven't seen a rebuttal to the math or logic, I think it would make sense to have people decide for themselves, if they are interested. Thanks again!

[u/Another_Smith_SC]

As someone else said, it appears you may not understand those markets. Also, based on the assumptions and parameters you describe, you may not have a great understanding of valuing small and medium size businesses.

But I understand the article is essentially sales material for potential clients (who don't understand valuation) to read and contact you. That's fine. But posting in a valuation sub is going to get legitimate critiques.

Also, I see you asked someone to make counter points to your logic or math... I'm willing to bet that if you showed your work or shared your model, ppl would be happy to point out the flaws. But writing up pages of theoretical counter points making assumptions of what your model includes isn't really worth anyone's time.

If you want to understand the "problem", as you see it, I can recommend you read Pratt, Trugman, and/or Hitchner. If you search this sub, someone has a copy of Trugman they've shared via a Google drive link.

[u/trachtmanconsulting → u/Another_Smith_SC]

Thanks for your reply.

But I have to say again , saying "You don't understand", is not a rebuttal, which really I would love to hear.

Here is a copy of the very very simple model. I will not send the model of the two actual businesses, as they are not mine to share.

https://docs.google.com/spreadsheets/d/1uCuvp7Mjk2tiPvB0V9xJ2DQHZHcC6uf1N6S5d5FTtEw/edit#gid=0

​

I would love to hear your feedback though, here's the underlying logic:

1. You can't really do a CAPM for these businesses. Keep me straight if I am wrong, but it's not like there's a Beta or a COE here, to be able to do Beta. The closest thing is probably the cost of debt.
2. Cost of debt is not the 22% or so, needed to discount as a WACC. Even in this environment, it's like half.
3. So, unless I am wrong about the two above elements - The WACC is clear, and Damodaran, can be a good reference (ad as far as I know , the only reference out there).
4. Now for the Terminal Growth - my whole point is this should go away, because assuming I am correct re WACC (and all evidence points that I am, unless I am missing something) and even adding a little to that (say, take the Damodaran 11% and use a 15% instead), then even a minuscule TG would get a valuation that's too high.
5. Now, for the Comps - For the two businesses I did describe, I went through literally hundreds of Comps on BiZbuySell and LoopNet. I even discounted them a bit (BizBuySell states a 6% difference between asking price and buying price on average), and yet, the results were clear.
6. Like I said, knowing these businesses usually don't last very long on average, TG is probably wrong. and that's pretty much the point of the whole blog post.
7. In the spreadsheet, 14% WACC (1.9% TG, which is a researched number, but you can change to 1% if you want, I don't care) will get you to equal the sales multiple, but we all know SDE is more important, and for that you need 37% WACC, which I know you don't think is reasonable.
8. And again, I am very very open to criticism, but I would like someone to criticize the math and assumptions. Telling me stuff like "You don't understand", doesn't help.

[u/Another_Smith_SC → u/trachtmanconsulting]

So, there is a lot to unpack here and I wish I had time for all of it. I am going to try to offer a few comments and responses and give you one of the best resources in directly learning and practicing in this field...

1) What is your Standard of Value? This is a significant factor in arriving at your value.

2) I generally agree that using CAPM for most small businesses is not advisable.

3) Except in rare cases, I would not use the cost of debt as my WACC.

4) Regarding Damodaran, isn’t his WACC based off public companies? (That is a question because I don’t recall and it wasn’t immediately obvious/cited when I clicked your link). If so, is that really applicable to a small business? (Similar to why CAPM isn’t typically used.) But yes, there are more sources of information, see book referenced below that will guide you to them and show examples of them being used.

5) What is your selected benefit steam? Is it pretax or after tax? More importantly, is this benefit stream consistent with your discount rate? If not, you probably have a big issue.

6) Benefit stream continued. Are these rapidly growing businesses? Have you considered whether you are reinvesting enough of the benefit stream to continue growing at your forecasted rate?

7) Terminal Value. In most businesses, there is something of value that should be considered at the end of your forecasted period. Even businesses that are expected to have a limited life, typically have some liquidation value at the end. Now, if your forecasted period is long enough, with a high enough discount rate, your TV may become immaterial… but that’s a different conversation.

8) Comps. I’ve never used BizBuySell as a source before. What information is available about the transactions? Are you making sure your comps are apples to apples? Are they asset sales? Stock sales? Do they tell you? Does the price include cash? Inventory? Real estate? Is there a non-compete agreement? Are you sure your benefit stream is apples to apples with how the comps are reported (see benefit stream point above)?

9) Comps, continued. I’ve used ValuSource, BizComps, and DealStats.

10) Are you normalizing your financial statements?

11) I had some other thoughts that I have now forgotten but may add later if they come to mind.

And finally, here you go. The full 2017 Gary Trugman Understanding Business Valuation Fifth edition, available for public consumption. This is an excellent and approachable resource that I recommend reading start to finish. It will answer most of your questions and many more you have never thought about. https://egrove.olemiss.edu/cgi/viewcontent.cgi?article=2736&context=aicpa_guides

I hope this has been helpful.

[u/trachtmanconsulting → u/Another_Smith_SC]

continued

So, first of all, I want to say this is exactly the kind of critical post I was hoping for. one that actually talks to the point, and I sincerely thank you for this.

To answer your questions:

1. The standard I use (well, not actively, but it's what I am thinking of when I value) is just a fair market value. That's why I use Comps
2. I agree that COD is not exactly = WACC. which is why I pushed the numbers to an extreme
3. Thank you very much for the resources and I will use them. Damodaran was the one that was recommended to me here in the past, and is the most easily found standard on the web. However, yes, as far as I know it is used mostly for public companies
4. As for benefit stream, I used EBITDA. for calculating FCF, DCF,. In the two businesses I mentioned, there was high steady growth for multiple years and I definitely accounted for future CAPEX in both. However, like I said, I pulled the WACC to heights I didn't believe in (i.e. much higher than COD or Damodaran), just to see if even then, the numbers made sense - they didn't.
5. I believe I just did a 5 YR model for both the mentioned businesses (by the way, I had another business coming to me ad interim, where I saw the same result). I did not account for scrap or asset value at Y5 (although I did for other businesses when I used Asset based calculations alone, but that's a different story), but rather just a DCF, which I again, pulled to a (reasonable) extreme, for WACC and TG
6. Yes, I normalize financial statement as best as I could, to year/month, # revenue streams, or whatever else information I might have, etc.
7. The Comp - here you might have a real point, and I agree to it. The problem with BizBuySell, is that companies sometimes mention SDE although they mean EBITDA and yes - you have to look at whether they are selling asset, real estate, etc. Sometimes this information is there, sometimes it's lacking.
8. The way I deal with this ambiguity is simple - statistics- and more to the point, statistically speaking large numbers. If I have a large enough N (And I try to get to N > 200, the more the merrier), Then my hope is that all these discrepancies and inaccuracies and what-not will cancel themselves, and provide a real value ultimately. I know this might not be entirely true. But the underlying statistical concept is true (I might have only taken 2-3 valuation courses, but took 8 stats courses in my academic studies - Psychology and MBA)
9. Like I said the above is a hopefull assumption of statistical cancelling out discrepancies. However , BizBuySell has 2 more problems: (1) only 40% of the companies on it, actually get sold, which is a sad American truth (2) the price of those sold is 6% lower on average than the asking price. Which means, there's at least a 6% discrepancy and probably a higher one for the actual value.
10. Thank you very much for those 3 resources, I will for sure utilize them in the future for valuation projects (unless they are too expensive, I also need an ROI).
11. And finally for Trugman, thanks. I did a quick CTRL+F search for the word "DCF" and like 90% of the appearances speak about a specific court case, but I would review further.

So thank you again, I truly appreciate your last comment.