Date published: November 25, 2008
It's back to school time so I thought I would reflect on my first finance course and its application to the dealership world. Finance 101 teaches MBAs the important concept of business valuation. When a private company is being acquired, its fair market value is best determined by two methods: (i) comparable company analysis, which applies an earnings multiple to current profits, or (ii) discounted cash flow (“DCF”) analysis, which applies a discount rate to expected future profits. Because both methodologies are quite involved, I will dedicate this article to comparable company analysis and next month’s article to DCF.
Comparable company analysis provides a good estimate of the present value of a company, including its goodwill (blue sky), tangible assets and working capital (excluding debt). The key to applying this method is making sure the earnings multiple, which is determined looking at comparable public companies, accurately reflects the risks associated with the investment. As a rule of thumb: businesses with higher risks are valued with lower earnings multiples, while businesses with lower risks are valued with higher multiples.
What does this all mean? Well, it means that if you are buying a company that does not appear to have a lot of risk associated with it (say a Honda dealership) you are willing to pay a higher earnings multiple. Conversely, if you are buying a higher risk company (say a domestic franchise) you are only willing to pay a lower earnings multiple. In today’s challenging credit market, the entire dealership industry is higher risk and thus most multiples are lower to reflect the industry’s systemic risk.
It should be noted that nowhere in Finance 101 is there a discussion of goodwill or blue sky multiples. The way in which most dealerships are valued is inconsistent with the principals of finance in which a present value is calculated for the entire equity purchase of a business, including blue sky, tangible assets and working capital. For one thing, blue sky multiples are not analytically calculated and are often determined either by the seller’s price preferences or the buyer’s instincts, with little to no valuation analysis. In fact, it is rare to see a full pro forma of a target dealership’s future earnings. The blue sky multiple valuation approach might have sufficed when we were in a strong, growing market, but today it is inadequate. In a challenging economy with declining car sales, a buyer needs to be more precise with dealership valuation. Overpaying can result in disastrous results.
Comparable company analysis
Comparable company analysis assesses how comparable public companies are being valued in the stock market and applies a similar, valuation metric to obtain a private company value. For dealerships, we are fortunate to have five profitable public companies from which to collect market data and valuation metrics. The most applicable metric is the price to earnings (P/E) ratio, which measures a company’s equity market value to its current earnings. (One can also look at enterprise value to EBITDA as another valuation metric, but for simplicity sake, I am going to focus only on P/E in this article). As can be seen in Chart 1, on September 19, 2008, the average P/E ratio for these public dealerships was eight times.
Before you get too excited about an eight times multiple, a public company P/E must be discounted by between 35 and 50 percent before applying it to a private company’s earnings for valuation purposes. This discount reflects the lack of marketability and liquidity associated with a private company as compared to a public stock. The more liquid a company, the higher that company is valued by investors. By applying this discount rate the P/E multiple declines to a range of four to five times. (See Chart 2)
Of course, the public companies reviewed in this analysis derive on average 79 percent of their sales from import and luxury brands and 21 percent of their sales from domestic brands. To calculate a distinct value for import/luxury versus domestic, we can apply a weighted average to obtain a range of multiples for differing franchises. In the table below, using the weighted average of 5.2 times, we come up with an import/luxury P/E multiple ranging from 5.8 to 6.3 times and a domestic P/E multiple ranging from 1 to 3 times. (See Chart 3)
Taking into account additional factors such as geographic location, proximity of competing franchises, local economy, and real estate requirements, you can adjust a multiple up or down slightly to reflect the value of the dealership being acquired. Once you have determined the right earnings multiple, this multiple is applied to the dealership’s net income after tax to determine the entire dealership’s equity value. To be clear, this value is not simply for the blue sky, but rather for the whole business including tangible assets, working capital and blue sky (when buying a public stock, the P/E is not quoted excluding tangible assets and working capital). Also of note, dealership earnings should only be adjusted for items that are not related to the business or are truly one time occurrences.
I understand that this form of valuation may seem strange to the private dealership community. However, as our industry continues to mature and consolidate, Finance 101 business valuation will likely become more commonplace. In any industry, paying the right price for a business can determine the investment’s success. When dealerships are valued with the right metrics, buyers will make better investment decisions and achieve better returns on their invested capital.