How do you know how much to pay for a company? There are many ways to be an entrepreneur, one of which is to just buy a company. Typically, you would buy a company because you have some level of expertise about a company’s operations and you figure you can operate “better” than the person or company you are buying it from. In other cases, you have a company, big or small, and the addition of another company, perhaps similar, will help the company you own to become a better company or you eliminate some competition. In the later case, it’s the extension or growth of an entrepreneurial enterprise. Large, extremely large companies make the same types of decisions or calculations. The central question boils down to, “how much should you pay for the company you are considering acquiring?” The same question or one very similar can and should be asked about starting up a company, although, the amount you spend on a startup and the growth potential is a little harder to measure, kinda. But, for sake of this post, let’s just stick to buying a company.
Just as a point of reference and how I will end this post, this is relating to Blue Diamond as I struggle to determine an offering price for these assets. I say assets because I’m not really buying a “growing” concern, per se. Checkout what I wrote about what I’m trying to do on the page describing Blue Diamond.
I addressed some of the valuation twists on the “Show Me the Money” page but this gives you a little more insight into approaches that might be used, and that have used and I’m using now on Blue Diamond.
Let’s start here. Ask 10 people how you evaluate a potential valuation of a company to buy or assets you want to buy and I promise you will get 20 answers, maybe more. A good valuation decision will use multiple methodologies and data points to determine the price to pay for a company. I probably should separate negotiating from determining a price. Most companies and when I say companies, I really mean “analyst” have a definitive value they will want to pay for assets or a company. The people negotiating the purchase price will pay less or more than the determined value. In some cases, you can afford to “overpay” and not be harmed, post-acquisition but you will probably have to make some adjustments or decisions regarding operations or financing to “Make the Numbers Work.” For instance, if you overpay, you might have to “layoff” more people than you originally had planned. You may have to resell some of the assets you purchased or you may have to take more money out of your pocket to use an “equity” or as a down payment, assuming you’re financing the transaction by borrowing money and making a down payment. As I mentioned at the top of this paragraph, 10 people looking to value a transaction will come up with 20 answers, well consider the banks/lenders providing debt and any “outside investor” in that number. Yes, banks value assets to determine how much they will lend and “equity providers” value assets to determine not just how much they will invest but if they will invest in a transaction. Hopefully, you will have or somebody on your behalf will have done enough analysis to determine how much to expect from the banks and the equity providers and an alternative if those folks come up with a different answer than you do.
The question is just how do you determine how much to pay for a company or assets?
I want to give an easy, practical answer and I probably should but I can’t. I could and maybe I will as closing to this page but in many cases, and with Blue Diamond, in particular, it’s just not that easy. It becomes complicated with respect to Blue Diamond because I’m using OPM, “Other People’s Money.” In transactions like Blue Diamond or Sunbeam you have to be aware of what they might want or need by way of getting their money back and what you want as a “company owner.” If you want to be an employee and get a wage, get a job. If you want to own, grow and, most likely, sell a business, you figure out the least amount you can pay for it to give yourself and others room to make a profit on the business, in addition to paying yourself a salary. You want the bump, the plus, the “come-upping’s,” the extra, not just the salary. When you value a business, you should/have to consider the “extra.”
Let me digress, just for a second. I am having a conversation with a friend of mine some years back about a business idea he had. I debate about sharing the idea because I don’t know if anybody has done it or some variation of it yet. He’s an accountant too, not that we’re bad people but typically, we look at shit, particularly businesses, through a conservative lens. I happen to be more risks tolerant than most but if I think about shit too long, my aversion to risks will seep out.
Anyway, with the business idea he had or somebody he knew had, he was trying to evaluate the success of the business base on the cash flow it would generate. It was a kind of a “tech-based” idea that had the ability to produce some cash flow on an on-going basis but the “extra” wouldn’t come unless the business was sold. I had to slow him down a little because he was discounting the idea because it wasn’t going to be a “pay as you go” business. I told him tech business models where different than the traditional business models. Most early tech deals are developed with the intent on being sold and the extra was going to be had at the time of sale, not on the “pay as you go” model that many businesses are valued on and the way most entrepreneurs and bankers might view them. I’m going to get to this later but when you’re using cash flow to value a business you have to use “all” cash flow to determine the value, not just the “pay as you go cash flow.” Now, the “pay as you go cash flow” is critical if any of your “financing” includes debt/borrowed money That’s a tease for geeks.
I might have mentioned that I was a finance major in college. I had more accounting hours than finance hours but my actual degree is in “Banking and Finance” rather than accounting. I guess since I digressed a little I can tell this quickly.
When I went to college, my stated major was Accounting. The plan was five years and finish up with a Master of Accountancy. I had an internship after my sophomore year with an oil company and realized the amount of money I could make right out of school and switched my major to begin my junior year to finance. So used those final two years loading up on finance courses and squeezing in enough accounting hours to get me eligible to sit for the CPA exam because, in my mind, I was still going to be an accountant but with just degree in Banking and Finance and that’s what happened. I didn’t know that I would be as stimulated by finance as I had already been by accounting. Samething with Economics but that’s another story for another day.
There were a couple of finance classes that really intrigued but one that stood out, Financial Theory. That class was hard as fuck but has since become the basis for the primary “asset pricing model” that I use to value companies, assets or businesses to purchase. The methodology is not unique to me or my approach but for me, some of things I learned make some of the other valuation methodologies look, well, insane. The truth is, I have worked for a bunch ofcompanies and had the privilege to get some inside scoop and Birdseye view of evaluating assets to purchase, projects to pursue and key “how we should spend the money” decisions. Let me say this, giving credit to people because they are in high places in a company and have make buy/sell decisions, is a mistake. Sometimes, they get luck and a lot of times, well, you read the paper.
I haven’t forgotten what I’m supposed to be telling you, “how to value assets.” I just needed to share a couple of back stories.
Have you heard of “internal rate of return” or “net present value of cash flows?” How about “debt service coverage ratio” or “payback?” Maybe you have heard of “earnings multiple” or “P/E” or price- “earnings ratio?” Unless you’re a finance or maybe accounting “geek” you probably haven’t and now is not the time to do a class on what, in some cases, can a full college semester tryna understand finance or financial theory so fuck that. Let me make this is simple as I can without losing too much, just in case some financial geek decides to challenge me.
When you’re valuing an asset, a company to buy or business to start, the primary thing you want to think about is, “how much cash is this asset or company or business going to generate for me?” The next thing that is equally important and more important is, “when do I get the money.” Finally, the other piece to this 3-legged stool is, “how much do I gotta pay to get this money?” There’s a lotta shit that makes the 3-legged stool stand but you can get your arms around these 3 legs you can make a good decision about the price to pay for a company. Let me say this before somebody gets their panties in a wad this is an over-simplification and the process can be extremely complicated and involve an army of people to answer those questions but that’s it. I don’t care if you’re buying a shopping center, drilling an oil well, buy a CD, buying a bond or acquiring assets to start a convenience store company, doing the financial analysis is the same. Now, the risks associated with getting the assets to generate the cash flow, that’s the process of managing the business which can be as tricking as getting legs of the stool balanced. People and big-ass companies will come up with all kinds of stupid shit determining how to balance the stool AND understanding how to manage the risks associated with assumptions made to make the stool functional. With Blue Diamond, all of this is my job, right now!
I say all of this is my job. In doing a “start-up” acquisition using OPM, it’s my job to find the facts, make the assumptions and sell it to banks and outside investors to make this shit work. What I know, as I mentioned above, is that banks and the private equity fund that I will use their own analysis to determine if this deal is worth it for them. They keys are, do they believe my assumptions and do they believe in me to be able to pull it off. That’s separate and apart from what they want, particularly in the case of the PE firm.
Let’s spend the last part of this talking about what I’m doing to gather the information to put Blue Diamond together then how I’m approaching the valuation. In reality, this is truly the “Aspects of a Deal.”
I already went through how I identified the stores I’m targeting ion the Blue Diamond page. It’s probably important to read that again since I’m not going to repeat it here, not really. Some of what I will say here might make more sense if you understand what I’m dealing with and in summary, I am dealing with a sack of shit.
In most cases, I should say in a lotta cases when you’re buying assets, the assets will have a history of performance or some kind of record that you can use as a point of reference. A Profit & Loss Statement or Profit & Loss Statements that will give you an operating history. It doesn’t have to be a stellar history. I mean you don’t have to buy assets that have made money for the last 3 years or 10 years. Hell, you can buy a company that has been losing money forever. If you can point to what that looks like you can say, “you’re going to fix this or fix that” or “pursue these new customers or markets” or “change this or change that.” If your plan(s) make sense, and I mean to somebody other than yourself, you might have an opportunity at a deal. You can use the same logic with an underperforming asset, an asset that is not making as much money as you believe it can. You can sell it to somebody else, particularly if you’re using OPM, you might have a deal. I’ll get to selling it to somebody else in a bit.
Keep this in mind as I go through these next topics of conversation. In assessing how much you want to pay for a company or assets, you need to determine, how much cash that company or assets will throw off or generate. This is before you pay any loans or payback any investors. Do it with your salary or compensation in it, I mean reasonable compensation, like a salary. Your “extra” is after you get the OPM back. Remember this as I go through this next section.
When you gather historical information, you have to vet it. Be sure that shit makes sense. As a matter of fact, you should rebuild the history using “new” assumptions. What I mean is, let’s say the current or previous owner is using TXU for electricity. I’m keeping this simple and I will get to the Blue Diamond assumptions in just a minute. When you look at the historical Profit & Loss Statements, get an estimate of what Reliant Energy or some other electricity provider will charge. Hell, depending on what you’re doing, evaluate what it might to take to do solar panels. Look at, office rent, equipment leases, insurance options. Look at all of that shit and see if you can save money, big money. Make notes on where the savings might be. What do big companies look at when they are evaluating other companies to buy? The look at overhead savings, where they might be synergies that can be generated from having common HQ staff, layoffs.
If you’re buying a company as your starting point, like I am with Blue Diamond, you don’t have the luxury of considering “consolidations” as an opportuning to improve cash flow. In the “consolidation” example, reducing cash expenses counts the same is a new review. Cash is CASH.
I started with expenses because that shit is easy. I mean you don’t have to say, “well we are going to get these new customers from XYZ and have to sell somebody your “charm” to get XYZ, that is if you don’t already have a contract with XYZ. Blue Diamond is will be a “retail” enterprise, at least to start so I’ve got to sell to those “Other People” that I can generate new foot-traffic by doing that shit that I will be doing.
Bottomline is this, you have to determine what you’re new “Cash Flow” is going to look like, post-acquisition. You need to turnover every rock, twice, to be sure you know and be able to sell what you’re new Profit & Loss Statement, your “pro forma” income statement will look like.
For Blue Diamond, that is a bitch! There are not Profit & Loss Statements, just my assumptions. The expenses assumptions are easier than revenue assumptions. Here’s what I mean in a couple of instances.
Salaries or compensation is a perfect example. I know the store operating hours in most cases will be 6a-10p for most stores. Based on where the stores are, I can get a pretty good estimate of how many employees will be needed to cover the shifts. I know there has to be some overlap on some stores to get some shit done, operationally. I’ve even made store work schedules for each store and by position. I know that I’m going to need a store manager for some of the remote stores. There is a cluster of stores in one of the towns so I’m considering a regional manager concept to lower labor costs. I also, know, generally what the hourly comp is going to be. I know I need to be competitive so I can really just pretend I want a job at a competing store and ask them how much they pay. Fuck it, places like QT and Buc ee’s post their wages at the stores. Not that I would pay that much, necessarily, but you get my drift. Determining hourly wages and compensation, in general, is not rocket science. The challenge is being realistic about what that number is and not cheating or lying to myself about what is realistic. Done, I’ve done that.
Do you know the one area of Blue Diamond that has got me all fucked up? Insurance, employee insurance. That shit is expensive. I can’t get away without offering insurance. This is an example of being realistic and using good numbers to understand the projected cash flow.
I have gotten insurance quotes from an agency that does health insurance. My monthly quote for 19 people ranges from $6,000 per month to $15,000 for companies from Blue Cross to United Healthcare to Aetna and others. That’s the total costs, before any employee/employer sharing of costs. The right answer is probably somewhere in the middle but that is a lotta fucking money, an amount that is sure to rise year to year. The point is, it’s a number that I can get my arms around and that I must use to determine projected cash flow, a number that I can’t get from the seller because he doesn’t have historical information.
Last one it this example. Since there is now “corporate infrastructure” there is not information on licensing fees for “systems.” Computer systems are a big part of how I will manage the business and that shit ain’t free. I have an upfront cost to get the setup of the system then a monthly or annual cost for licensing and maintenance. Put a pin in the “upfront” comment. I’m going to come back to that in a bit like a wrap up this valuation conversation.
In evaluating the data or projecting the prospective “cash flow” for Blue Diamond and I have gone up and down the entire P&L statement, by store. I have to have a narrow range in cash flow by store for say 5 years to I can figure out how to value the acquisition, it’s one of the legs to the stool and it’s made very complicated because there is not history to leverage.
Let me discuss revenue cause that is the most important and most challenging piece of the P&L and this whole fucking transaction that will be the final make or break or go no-go decision.
The expenses are easy, I mean easier. You just call or email somebody or just be generally fucking nosy and you can get to the expense, pretty accurately. The challenge being sure you identify all of them. That is easier said than done, for some cases. There is a school district with their nuts in a diaper because a “budget analyst” fucked up. Different story for a different day. If I fuck this up, two things might happen, either deal won’t get done or I will have my nuts and ass in a diaper on the other side of this transaction.
Back to revenue. Without historicals I have to project revenue for all of the following:
Gasoline Volume – actual dollar sales are easy if I get the volume. For sake of the projections, I’m using $2.50 per gallon.
Diesel Volume – ditto, same as gasoline except, I’m using $2.60 per gallon.
Gasoline & Diesel Margin – I’m not putting that in this post but the range for margin, the sales price minus that I pay for fuel, changes daily and can be small or larger. I have a constant projected that is probably on the higher side. There’s a strategic reason for that, that I might mention in a later post.
Inside Sales – inside sales include grocery/snacks, beer & wine, cigarettes, lottery dairy, and other stuff. I have broken it down just like that in my assumptions because the margins are different, significantly for each category. Like lottery the lottery margin is only 5% but a fountain drink margin might be 200%. You really can’t use a “blended” margin because of the varying store locations. For instance, there is one store that won’t sell alcohol because of the size of the store. Not enough room.
Quick Serve Restaurants – I haven’t made any assumption about restaurants that might go into 3-4 of the stores other than 3-4 of the stores will have restaurants and made a list of 20 possible franchises that might work. To be honest, the restaurant play might be what makes or breaks this deal.
This shit is complex and hard to sell to anybody without historical information to support it. I have already been asked for historical support or a magic 8-ball from banks and my equity partner, that is prospective equity partner. Once I get close enough to a valuation I think it makes sense, I’m going to order a study for what I consider the two most profitable locations to verify my assumptions. These studies are going to cost me about $2,000 for each site. So, $4,000 to support my guess and then $28-30,000 to complete the package, if the deal makes sense with my assumptions and I can get the seller to agree to my purchase price.
Revenue, for Blue Diamond, is hard as fuck to predict, particularly for these stores. The site studies will be critical. The banks, the private equity company and Texaco are all going to rely on these studies to determine if this deal is going to make. I mean, my use of those studies in putting together the analysis that will support my valuation will get them there are tell me to fuck-off. It’s really that simple.
Why not start there? There are more pieces to this puzzle than that and I ain’t spending $30,000 until I can figure out if the legs to the stool might be sturdy, or not.
Just to wrap up and move on from the P&L. Getting to the cash flow is one leg to the stool. Hopefully, you see what it takes to get there. When I pull all this shit together you will see how important that is, how equally important that is to get to a valuation.
Early I said, the 3rd leg of the stool is “how much I gotta pay to get the cash flow.” I want to talk about that next. The order doesn’t’ really matter if it’s a 3-legged stool cause all the legs gotta be balanced, right? Or, otherwise your ass is gonna fail, I mean fall.
How much you ultimately pay for anything is largely based on negotiation. It really is. I mean if somebody is trying to sell some shit and you think it costs to much you can either overpay or walk away. I guess you can say it another way like if you want to buy something and the costs are not to your liking you can walk away. Sounds the same but you don’t always have to overpay, sometimes you get a bargain and feel like you underpaid, I guess.
Blue Diamond is kind of a unique case, kinda. The stores I’m pursuing are not for sale, collectively. He’s selling shit individually, when asked but he has not bundled them and said, “I’m selling this group of stores.” I approached him with a proposal to buy them. If you read Blue Diamond page you know it was an unsolicited proposal from me to him. I haven’t given him a price and he hasn’t proposed a price which makes my valuation critically important. I don’t have to worry about him asking too much, not yet, because he doesn’t have a price in mind. What I must guard against, I guess, is insulting him with a low-ball offer. Look, almost every mutha fucka thinks his shit is more valuable than it is, even when he or she hasn’t placed value on it. You can think of “shit” in the broadest terms you can think of.
I put cash flow on the shelf for now. I’m not using it for the valuation yet, not really. I’m just trying to figure out what cash flow is so leaving it on the shelf for now. What I want to try to figure out now is how much it’s going to take to “fix” these raggedy-ass stores. In some of the previous posts, I share the challenge I faced in getting people to be responsive if give me quotes that work. I got that and this shit still has a hold on my nuts. Insurance was kind of shock but the repair and renovation costs, have knocked me the fuck out. Let’s talk about it and I’ll share some real numbers, promise.
Here’s a weird place to start.
With a convenience store, there are 2 major revenue categories, inside and outside. It’s simple and when you look at it in these terms. If you scroll up and look at how I described how I’m tying to feel in the pieces of the Profit & Loss Statement you can see why I’m sharing this the way that I am.
One the outside there is gasoline. Most “regular” convenience stores sell just gasoline and may sell diesel out of one or two nozzles. Some larger convenience stores have a “truck fueling” island which is either in the back or on the side of the primary convenience store and the primary “gasoline” island. This is true for “truck stops.” The gasoline island can be branded, in my case, Texaco, or it can be unbranded, like a QT or a Bucee’s. In either case, there is a complex “fuel distribution system” tied to that gasoline and or diesel island. That systems include the pumps that you see and use but also underground storage tanks, tank monitors, lines that tie the tanks to the pumps and point of sale system that is used in the stores for the cashier to know what you bought and to record your sale. It’s pretty cool the way it functions. The process is old as hell and has worked the same way for year. I mean years. The system that I used for my Conoco stores is the same as it is today and almost the exact same as my dad used almost 40 years ago for his Gulf store. The only thing that has changed is how much that shit costs to buy, install and maintain.
My “guess” or estimate about how much that shit was going to costs, I wasn’t’ even kinda close. In my original model, I had to replace the fuel system estimated at like $150,000-200,000 each for the largest two stores. I kid you not, that quote just one of the large stores is $875,000. I was floored. This is rough estimate and could be a little higher or a little lower but I believe it is probably not too far from accurate. Here’s why.
One company that I had asked to give me a quote wouldn’t give me a written quote without very thorough and having all of the T’s crossed and I’s dotted. I didn’t want or need that for a lotta reason’s primarily that the plans for any given store are subject to change. For instance, the quote for first company gave me was for one of the smaller stores. The verbal estimate he gave me was for $700,000. That was more than I would pay for that entire store in my wildest imagination. What he wasn’t giving me the option to do was say, not I don’t want this, I want that or let’s make this smaller or this larger or give me 3 pumps rather than 4. What also said that concrete was going to cost me $200,000. That was some bullshit. What I wanted was a rough estimate so I could look at what the costs might be across all 14 stores. Some of the costs the first company gave me lined up with the costs for the 2nd company gave, like for pumps. They were within $1500-2000 per pump so I’m comfortable that the estimates for equipment and “materials” were close.
So, the 2nd company gave me an estimate for one of the larger stores and I break it down and use the costs to get an estimate for the other stores. The fuel systems only are going to run me about $4 million. So, in my valuation, what I’ve got to do is match that up with the “building” renovation estimate and what I want to offer the seller for the actual purchase price.
I want to point out how this analysis might differ from company acquisition and how that shit is the same when it comes to valuing the “company” or the “assets.” I’m going to tie all this shit together but I don’t want you to get lost on where I’m taking you. This is pretty simple. No matter how many checks you right or who you write them to, the sum total of those checks is how much you’re paying for the assets. Remember I said you count “ALL THE CASH?” So writing a check to the seller or to the fuel system installer or to the contractor that renovates the building all are part of the “acquisition” costs and when I’m going the valuation, I have to consider all of this and try to find the right balance for the transaction and for the business. Imma repeats this again when I wrap this up but think about it as I go through the puzzle.
The fuel system is roughly $4 million. Now I’ve built a model by each individual store that tells me how it’s looking in turns of the value of each store, that’s how much it costs versus my estimate of cash flow. So when these big ass numbers come through, like $4 million I can make some quick assumptions, like, this store doesn’t’ really need 4 pumps, 3 will do based on the projected volume or this store doesn’t need 2 underground storage tanks based on the projected volume, let’s do 1 larger tank and divide it into sections. Those kinds of “gymnastics” are helping to make some decisions about the value of individual stores and the company as a whole.
Back to the costs of the stores.
One of the challenges in getting estimates was getting an estimate for the renovation of stores. In an earlier post, “Race Does Matter” I referenced a company that was doing some work on a new store and stopped to get the name of the company to see if I could get them to provide me a quote for the construction of stores. Turns out they were really helpful. I hope my tone in this post is one of shock, cause it is. Long story short, this company provided me a guide to using for renovating and constructing new stores.
I mentioned in earlier posts and in this post that these are really shitty stores, I mean unkept. I wish I could provide pictures, but I just can’t, not now. One of the conditions for the Texaco contract is that I tear down and rebuild several stores, 5 actually. In addition to razing & rebuild, I am going to the other stores, all of them. What is required will vary from store to store. I’m going for a particular image, that’s colors and graphics for each store. The easiest model to grasp is 7-11. 7-11 has co-branded most all of its stores, so far. I think Circle-K and doing the same thing. The store has one brand, image, 7-11 and the fuel island has a different brand, say Exxon or Shell. I will do the same thing, the gasoline island for most of the stores will be Texaco. I haven’t come up with a store brand but I do have a color scheme and graphics that I will use. I will have a store brand/logo at some point. Here is an example of the dual branding I did with the Conoco stores.
The estimate for the raze and rebuilds is $225 per square foot of building space. For one of the larger stores, that will be a raze and rebuild is $1.1 million. You keeping up with the math? For that large store, we’re at $1.9 million and we haven’t bought the real estate. The renovation for some the stores that do not raze and rebuild is $45 per square foot of building space. For the smallest store that is about $50,000. The range for the renovation of stores is from $50,000 to $125,000. I don’t think all stores will need $125,000 of renovation costs but then again I was shocked the fuel system costs of $800,000. I’ll use the higher numbers.
The total building renovation or building costs is $3.7 million. If you’re keeping up, we’re at $7.7 million and that doesn’t include any money to the seller. I haven’t scrubbed by stores to see if I can get this lower based on work that might be done. It’s a rough barometer of where I am. Let me reiterate, this not the valuation but the part of the acquisition costs. The big deal is how does the valuation stack up to the costs. We’re getting there.
The construction costs and the fuel system cost are the largest of the acquisition costs associated with the Blue Diamond acquisition. What the seller will take is going to be big as well but it is much lower than it otherwise, would have been if I didn’t have to fix the shitty mess. You could make the argument that the sales of the stores would be larger if the stores were not as fucked up as they are. If we were not doing a turnaround the seller could ask for or demand more. The risk would be lower. I already had one private equity firm tell me “no” because it was a turnaround. I have the ear of one PE firm because of the Texaco relationship. I just can’t overpay.
There are some other costs, lesser costs but critically important to get this done, like the systems. The cost of putting the system in place is going to be roughly $200,000. This infrastructure is critical to the success of the deal, post-acquisition.
Let’s put a bow on this topic. Of course, I won’t share my actual valuation but I will go through how I am going to approach it. I also, won’t tell you what I’m going to offer the seller. What I will tell you in a different post is if he accepts my offer and how we’re going to get it done.
As I mentioned at the top of this post, there are a lot of ways to value a company or an asset. There are a lot of reasons to buy a company or assets which I won’t get into since the post is about assets valuation; however, even when buying a company for a “strategic” or some other reason, there is still a valuation process you go through so you know how much to pay. As a wrap this up, keep in mind this one central fact: AN ASSETS IS ONLY AS VALUABLE AS THE CASH IT CAN POSSIBLE GENERATE, ALL THE CASH.
That last sentence is the shit. I mean, if you can grasp that you got valuation down. You don’t need the theory or have to be able to crunch the numbers but you have to keep that concept in mind. How does this concept apply to Blue Diamond and other companies or assets? This is my last point.
Within this post, I’ve referenced the 3-legged stool. Here is the exact shit I said. I’m copying and pasting here so I get it right:
When you’re valuing an asset, a company to buy or business to start, the primary thing you want to think about is, “how much cash is this asset or company or business going to generate for me?” The next thing that is equally important and more important is, “when do I get the money.” Finally, the other piece to this 3-legged stool is, “how much do I gotta pay to get this money?”
I already went through 2 of the 3 legs. “How much cash is this asset going to generate” is pretty simple that’s the cash flow or the P&L. When you get the “profit” or “cash flow” right you’re done with this leg. That number will continue to move as your analysis of the business prospects change. In a supplicated model, the cash flow will be different each year based on buncha shit. For my Blue Diamond analysis, I’m going to just assume that once I’m comfortable with a stabilized cash flow number, that number is going to be relatively consistent for like the next 10-15 years. That’s an oversimplification but I’m not trying to be extremely precise with numbers that are going to move. It’s horseshoes and getting close counts.
Did you miss that I just covered 2 of the 3? I snuck that shit in on you. I covered the timing on when I will receive the cash and you missed it. The assumption I’m making is that after the stabilization of the cash operations is that the cash flow will be the same for 10-15 years. Stabilization is the keyword. Let me spend a couple of sentences on that.
For Blue Diamond, I’ assuming that I will have a stable operation at the end of year 2. All construction is complete and all store is open and most are generating positive cash flow, obviously some more than others. Right now, with the analysis that I have now, a couple of stores are not generating positive cash flow or they are breakeven. I’ll answer the question that you have in your mind again about what I would want a store that’s losing money or at best is breakeven? I need to gasoline volume for the Texaco contract!
I mentioned earlier my conversation with my friend and the tech company, that the business model for tech companies can be kinda fucked up. What I was saying is the cash, the extra might be delayed, it might come much later. A tech company maybe breakeven for years and the “investors” may receive the extra when the company is sold. The extra will need to be enough to pay for that long wait. Facebook is a perfect example. The early investors got paid when the company went public cause the Facebook was not generating a profit or even positive cash flow or paying any type of dividend to those investors before it went public. Their extra or payout happened at the end of the “investment period,” assuming you consider going public the end game.
Stay with me because I’m about to throw you a curveball, or two.
The final leg, the 3rd leg, if you will of this pricing model as, “how much am I willing to pay for this cash flow?” Here is the curveball, at least for the way I look at company or asset valuation. The investment you make, the “cash out” to buy a company or an asset is part of the “cash flow,” it just happens to be negative. The losses you incur in the early stages as I might have in the first 6 months or so of Blue Diamond are all part of cash flow. Remember I said, ALL cash flow.
Are you good? Need to think about it? Read again because I’m going to layer some shit of top of that, some theoretical shit that I’m going to try to make as simple as I can.
Any investment model needs to consider the “time value of money” to get to be an accurate, or in my thought process, a meaningful valuation of a company or an asset. There are a lot of industries that use models that don’t consider the time value of money. I’m not going to name them cause I don’t need that headache of people bitching at me. I’ll say this, I play in one of those industries, sometimes.
What does the “time value of money” mean and what the fuck am I talking about?
The concept is pretty simple. If you’re investing money, the sooner you get your money back with your earnings, the more valuable that investment is. For instance, if you invest $1,000 in a savings account that pays 5% interest. If you get your $1,050 in 6 months, it has more value than if you get it in 1 year. Why cause now you can invest that $1,050 sooner than having to wait 12 months to pass. To get true return, you have to consider that it only took your 6 months to get that $50 than 12 months. I’m not going to make it any more complicated than that. That’s about as simple as I can do in explaining the time value of money.
So, what does that mean relative to Blue Diamond and valuing assets? The “outlay,” the “investment” to purchase the store assets is measured by the time it takes to get the money back. There is an assumed interest rate or rate of return that is included in the calculation. Let me say it another way.
For shits and giggles, let’s assume the total costs of the stores, that’s acquisition, fuel systems replacements, purchase, and infrastructure, is $12 million, just for shits and giggles. The series of cash flows start at ($12,000,000) in year one, maybe less than that if the stores generate positive cash flow, maybe more if we start year one losing money but for shits and giggles, is ($12,000,000), that’s negative $12 million. Over the next 15 years, beginning in year 2, let’s assume the stores generate $1.5 million in positive cash flow, that’s before interest and taxes. If you DON’T consider the time value of money, an investor has said they are willing to pay $12 million upfront to receive $21 million over the next 14/15 years. Throw the time value of money in there they will want to pay less to receive that money, most likely. Why? Receiving money or your investment and return on your investment is always, always, sooner rather than later. There is a math formula that you use to be precise but I’m not trying to be that complicated.
That’s the backwards way of saying for one of my closing statements. To value a company or an asset, you calculate the present value of the cash flows, how much is that cash stream going to be over, say in my example the next 15 years. You discount that estimate using an interest rate or rate of return that you would want then you can determine how much you would be willing to pay for that cash stream. The calculation isn’t hard and the math isn’t that hard because calculators do it for you. What’s hard is getting the cash flow right, including how much to pay, upfront.
Here’s the last thing that I’m going to say and is part of my thought process and will be or I should be, part of the private equity funds calculus. What’s the extra?
Private Equity funds are in business for the extra. I mean that cash stream is nice and they’re going to get their share but to get a 60-70% or more return, they’re looking for the extra. How do they get extra? There are a couple of ways. The easiest is the sale of the company. For Blue Diamond, they’re counting on a sale. They have asked me what “multiple” I or the can expect to get on a sale. What they’re asking is home many times net cash flow can the company sale for. For instance, in my shits and giggles scenario above, they’re asking how many times $1.5 million can I sale the company for? Is it 10 times cash flow or $15 million? Is that number 8 times? That’s a way to cheat to get to value.
Do you remember what I said just a minute ago, any valuation that doesn’t into account the time value of money is not a good way to determine the value of an asset or the company? a multiple of earnings doesn’t really take into account the time value of money unless you use the multiple as part of discount the cash flow. If you do that, then it’s huge. You go the cash flow plus the multiple. The timing of the sale will determine the ultimate return on the investment.
Last thing, and no less important than the 3 legs to the stool. Risks. I didn’t account for the risks associated with a deal. There are couple reasons why I saved risk for last and didn’t make it one of the legs of the stool, even though in theory, it’s a very signicant component of any company or asset pricing model. Lets be real. Different transactions present different levels of risks. A savings count is different than buying 14 convenience stores and as a result you would expect the return requirement or interest rate to be different for each, right? You have to assign a risk premium to different transaction. Said a different way, you want a higher interest rate, the more risk you take.
Here’s why I didn’t make risk one of the legs of the stool. Professional risks takers have a minimum rate of return for any project they take on. They don’t assign interest rates based on risk. If they perceive the risks to be too great, the just pass on the deal. They just won’t do it. As I mentioned, I’ve had a private equity fund tell me know. They perceived the risks to be too great because there are too many moving parts.
Damn, that was long. I hope it wasn’t too confusing. At the end of the day, this is the analysis I’m going through to determine, not only does Blue Diamond make sense but what is the value of the company and can I get to a “purchase price” that will be acceptable to me, the PE fund, the bank, and the seller. A lot of interests to balance.