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Going beyond the numbers

Going beyond the numbers

June 30, 2017

Here at cfg, we are certified to perform Business Valuations in accordance with the standards of the US National Association of Certified Valuators and Analysts (NACVA).

Not so long ago, we were engaged by two different car rental companies in Aruba to perform business valuations. The purpose of both valuations were to calculate the value of the company in case of a potential sale. Both car rentals are similar in size, revenue and net income. These companies are both focused on the tourism market.

Interestingly enough, while valuating both companies we ended up with two significantly different values. Company A was valued at 40% higher than company B.

You may wonder, how is this possible? How can two almost identical companies in the same industry, with similar numbers, have two significantly different values?

The answer is simple: “The strength of the discount rate”.

“The discount rate refers to the interest rate used in discounted cash flow (DCF) analysis to determine the present value of future cash flows. The discount rate in DCF analysis takes into account not just the time value of money, but also the risk or uncertainty of future cash flows; the greater the uncertainty of future cash flows, the higher the discount rate”.

While both companies are very similar in size, total revenues and net income, they differ in four significant areas which influence the discount rate;

  • The Switzerland Structure: The value of a business is influenced by the reliance of any one customer, employee or supplier. Company A focuses more on the European market, while company B focuses primarily on the South American market, which for the most part consists of tourists from Venezuela. Given the recent developments in Venezuela and the stability of the European market for the Dutch Caribbean islands, the risk on this specific factor is much higher for company B than company A.

 

  • Financial performance: Company A has had its financial statements audited by a “Big 4” firm for the last five years, while Company B only has an in-house financial controller that compiled its financial statements. The greater reliability of the financials of Company A, reduces its risk and therefor also lowers their discount rate as compared to company B.

 

  • Hub & Spoke: This factor measures the extent to which a business can thrive without the daily involvement of the business owner. Company A is owned by 3 shareholders, who also have car rentals on the other Dutch Caribbean islands. The management team is well structured, with each of their companies having 1 director and three managers. Company B is a family owned business, with the owner being the director of the company and the other employees being mainly sales personnel and car mechanics. Given the fact the Company B is very dependent on one person, while company A has a professional management team in place, results in a higher risk for company B compared to company A.

 

  • The Hierarchy of Recurring Revenue: Company A has long-term contracts with recognized tour operator from the Netherlands and Germany, which ensures rental of more than 50% of its fleet. This contract ends in 2019, but they have already started negotiations to extend the contract for five more years after that. In contrast, Company B, does not have contracts with travel agencies, which make their forecasted cash flows less reliable then Company A.
     

Businesses thrive on achieving and exceeding numbers, after all they would be out of business if they wouldn’t deliver results. The above mentioned factors, clearly indicate that it’s important to realize that the numbers are not the only factor that drives the value of a company. Focusing solely on the raw data can restrict a company from reaching its full potential. When calculating the value of a company, one must always look beyond the numbers.

Written by: Jo-Ann Martis MSc, CVA