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www.rockproducts.com ROCK products • May 2016 • 23 these numbers enables you to calculate the profit multiple for each of those transactions by dividing the price by the annual profit. By looking at profit multiples on numerous transactions, you can begin to estimate the "market" mul- tiple, and therefore estimate value of a company by multi- plying that company's annual profit by the market multiple. Unfortunately, this process is not as easy as it sounds, for several reasons. First, it is not always easy or even possible to obtain the pertinent numbers. In most transactions for privately held companies, neither buyer nor seller divulge the details of the transaction. Sometimes there is an announcement about the cash price paid, but there is often little detail about debt assumed, de- ferred payments, employment contracts and other details which can be significant components of actual value. And it is often very difficult to determine the profitability of the acquired company, especially in enough detail to compare profit figures from different companies. Most analysts use EBITDA (earnings before interest, taxes, depreciation and amortization) to calculate profit multiples because this figure "normalizes" many company-specific variables, but often details about interest, taxes and depre- ciation are not available. The second problem with profit multiples is that it is diffi- cult to compare companies with different risk profiles. For example, companies may face different product pricing, cost structures, growth rates or competition, and therefore have different risk profiles. If risks between companies are not comparable, the profit multiples are also not comparable. Another reason the profit multiple approach can be difficult is that the circumstances of the specific buyer must be con- sidered. For instance, two very rational and well-informed buyers might be willing to pay very different prices for the same company because the company is a great "fit" for one buyer, but not for the other. Despite these drawbacks, the profit multiple approach is widely used within the industry, at least for initial rough es- timates of the value of a company. For example, by spending an afternoon with a company owner and asking the right questions, a competent investment banker should be able to give a reasonable estimate of value. However, few trans- actions actually get done using just these rough estimates. Most large companies who acquire smaller companies use some form of the "cash flow modeling" method to confirm their initial estimates of value. And many owners want more than just a profit multiple estimate before they make deci- sions about selling, borrowing, etc. Cash Flow Modeling The cash flow modeling method of estimating value in- volves predicting the future cash flows the company will generate, then estimating what a potential buyer will pay for those future cash flows. This method necessarily re- quires a thorough investigation of the company and its mar- ket in order to enable detailed modeling of every operation of the company (each aggregate operation, each ready-mix plant, each asphalt plant, etc.), along with the corporate overhead structure. Projected revenue and expense of each of these separate operations is modeled, then the separate operations are combined into a company model. For a small company, this can be a pretty simple exercise. For a larger company with multiple operations, the model becomes more complex, and if the company is fully integrated, with multiple aggregate, ready-mix, asphalt and construction operations, and inter- nal transfers of products between operations, the model can get pretty complicated. The process of developing such a model generally involves considerable interaction between the analyst and com- pany management, as well as independent investigation of the market by the analyst. This leads to comprehensive understanding of the company's operations, market, com- petitors, risks and opportunities, which enables the analyst to complete the modeling, make appropriate assumptions about the future of the company's operations and develop well-founded estimates of future cash flows. Once estimates of future cash flows are obtained, the ana- lyst must then estimate how the market would value those cash flows. This involves "discounting" the cash flows to a "present value," a standard financial analysis technique. The judgment and experience of the analyst is critical in select- ing the "market" discount rate for that specific company, and is dependent on the perceived risk of the company. General- ly, the higher the perceived risk, the higher the discount rate and therefore the lower the present value. Maximizing Value Of course, estimating value is not the same as actually realiz- ing that value. For owners of small- and medium-sized com- panies, especially family-owned companies, the process of realizing value generally means selling their business, and selling a company can be a challenging, complex task. And maximizing the value of the company is almost always achieved through competition among prospective purchas- ers. Few owners have the transaction experience or broad market knowledge required to properly manage such a competition, whereas an experienced investment banker can implement a competitive bidding strategy while mini- mizing the impact on the owners and company. Charles E. Eaton is president of Eaton Capital Corp., a strate- gic advisory and investment banking firm which specializes in the construction materials industry. Eaton Capital is located in Mill Valley, Calif., and the telephone number is 415-381- 4300.