In a previous edition of AADA’s Automotive Dealer, BDO Automotive considered Dealership goodwill in the context of what it is and who ‘owns’ it. In this article we turn our mind to how a valuer might approach the valuation of Dealership goodwill.
In the absence of a fair market transaction occurring, the value of a Dealership’s goodwill is extremely subjective – nothing more than an opinion.
If ‘value’ is subjective, then that must mean the valuer will not get it wrong, right? Maybe, but if the assumptions applied to calculate the value are not supported by sound logic then the valuer risks getting it wrong – very wrong!
Anyway, when we talk about value what exactly are we referring to? Often we observe parties to a value discussion are referring initially to two different measures without realising. Think of the differences in, for example, enterprise value, fair market value, goodwill value and share value. Accordingly any discussion around value must begin by ensuring the parties agree on what specifically is being valued; a reference only to ‘valuing the business’ will likely lead to confusion.
Even when the parties agree on ‘what specifically is being valued’, they still need to contend with valuation terminology such as surplus assets, operating investment, capitalisation rates, normalisation adjustments, minority discount, control premium, strategic value, etc. There is a lot to think about but what exactly are these things and how do they translate to valuing a Dealership?
Let’s assume you want to value the Dealership goodwill at fair market value. You have heard it quoted many times before, but in the interest of making sure we are all on the same page, fair market value is defined as a sale price negotiated in an open and unrestricted market between a knowledgeable, willing, but not anxious buyer, and a knowledgeable, willing, but not anxious seller, with both parties at arm’s length.
Lesson 1 – when engaging a valuer, make sure they understand precisely what needs to be valued, which is usually determined by the purpose of the valuation.
That sorted, the valuer should then turn his or her mind to what is the appropriate valuation methodology, which will include the following commonly adopted approaches:
• Discounted future cash flows
• Capitalisation of maintainable earnings
• Asset-based valuation
• Market-based valuation.
Save the long-winded explanation of each approach. Let’s turn our attention to the most commonly applied valuation methodology with respect to Dealership businesses: the capitalisation of maintainable earnings (CME). The CME approach involves identifying a maintainable earnings stream for a Dealership and multiplying this earnings stream by an appropriate capitalisation multiple in order to calculate the Enterprise Value. Any surplus assets, along with other market value adjustments, are added or deducted from the Enterprise Value in order to calculate the notional goodwill value.
The maintainable earnings estimate may require normalisation adjustments for non-commercial, abnormal or extraordinary events.
Lesson 2 – understand the valuation methodology adopted by the valuer and why they believe it to be the most appropriate.
The CME approach is formula-driven and appears reasonably easy to follow, requiring the valuer to identify or calculate the following components:
+ Future maintainable earnings
x Capitalisation rate (think multiple)
= Enterprise value
- Surplus assets or operating investment (the same thing but calculated a different way)
= Goodwill value.
Looks easy enough, doesn’t it? Just apply the formula, right? Wrong! The skill of the valuer rests with their ability to logically determine the very subjective components of future maintainable earnings, capitalisation rate and surplus assets, or operating investment.
Let’s examine each of those components to understand just why they are so subjective:
- Future maintainable earnings (FME). Logically, the starting point will be to review historical earnings; however history is not always an accurate indicator of the future. None of us has a crystal ball, but a competent valuer should take account of a wide range of available data and their own industry expertise to form a view regarding the future.
- Capitalisation rate. Typically reflects the market rate of return an investor would expect to receive relative to the risk of a Dealership investment. It will consider issues such as industry and brand outlook, investor expectations, prevailing interest rates, quality of management and the liquidity of the investment itself. As a guide, Dealership businesses are generally considered to have a capitalisation rate of between 20 and 30 per cent. There is some science to calculating a capitalisation rate, which we will explore in the next issue of Automotive Dealer.
- Surplus assets or operating investment. Most valuers will refer to the balance sheet in order to identify surplus assets to be deducted from the enterprise value in order to calculate goodwill. This is a perfectly reasonable approach; however sometimes identifying what is ‘surplus’ can be difficult, especially for a valuer not familiar with the industry. BDO’s preferred approach is to calculate the appropriate operating investment, which puts to the side the financing preferences of the owner and normalises the investment required for things such as fixed assets, parts inventory, equity in used vehicles and sufficient working capital.
Lesson 3 – while the CME valuation approach is formula-driven, the components are very subjective.A competent valuer should therefore form a logical view using their valuation expertise and industry knowledge.
Rules of thumb
For many years Dealers have referred to an earnings multiple of, say, three, to arrive at a goodwill value. This is a rule of thumb, not a formal valuation approach, but it will often prove useful as a starting point and here is why: We have already established that an acceptable capitalisation rate for a Dealership business is, say, 25 per cent, which when applied to future maintainable earnings will deliver an enterprise value that represents four times the earnings.
Again, referencing the formula under the CME valuation approach, when we deduct the operating investment (or surplus assets) from the enterprise value we derive the notional value of goodwill. In our experience, the appropriate operating investment will normally pencil out at one year’s profit, assuming a benchmark profit based on turnover.
Therefore, four times normalised annual profit, representing the Enterprise Value, less one year’s profit (assuming a benchmark level of profit), representing the Operating Investment, approximates a goodwill multiple of three times earnings. This approach is no replacement for a formal valuation but is commonly used to start a conversation.
In the next edition of Automotive Dealer we will dive deeper into the more technical aspects of valuing a Dealership, including considering the capital asset pricing model as a methodology to calculate the capitalisation rate, and our approach to calculating an appropriate operating investment.
We will also consider some common questions raised with us, such as: before or after tax, do different investor types apply different capitalisation rates, and does the brand influence the capitalisation rate or the future maintainable earnings.
We will also provide an overview of our observations in respect to Dealership values and transactions more generally.
For more information, or if you have any questions about this article, you can contact Mark Ward, Partner, BDO Automotive, by emailing [email protected]