Valuation methodologies matter

December 1, 2006 By    

We all are basically in the same business, yet it is a curious fact that many of us see value in a very different way. This difference is important to understand as we attempt to grow and presumably increase the value of our companies.

Carl Hughes LP/Gas Magazine Columnist
Carl Hughes LP/Gas Magazine Columnist

The best way I know to demonstrate this difference in perceived value is through example.

Let’s keep it simple and look at an asset that most all of us have: the 500-gallon domestic above-ground residential tank.

Most independent operators in this industry, when asked about tank values, will address two data points. What is the cost of a new tank? What is the open market to buy and sell a good used tank?

This answer is that a new 500-gallon tank costs $900. Next, the going price for the same sized used tank in good condition is $300 to $500. Taking a midpoint on the used market one could assume that the average value of a tank is in the range of $400 to $900.

Company
Company

A much smaller but influential group within the propane industry sees the value of the 500-gallon tank based upon a formula that compares the amount of income that is generated from the tank to some market multiple.

Let’s assume that the annual demand is 800 gallons, the operating expenses are $.35 per gallon and that the market multiple is five times. In the chart shown below, we have added the variable of three different gross margins in order to make our point.

Note that as the gross margin cash flow increases, so does the valuation.

Comparing Valuation Results
Comparing Valuation Results

The cash flow valuation model is looking at the productive value of the tank, while the asset valuation is looking at some base residual value. The former is an investor whose primary world is to invest based upon an expected return. Presumably the buyer on a cash flow basis would value a tank that is not producing at zero.

Who uses the cash flow methodology? All buyers whose financial structure involves the servicing of capital in order to support the assets purchased. This includes all the publicly traded master limited partnerships and those buyers who use third-party debt and equity in order to make acquisitions.

Why is this method so important to this group? These companies have accessed capital that expects a rate of return – or a flow of income – off the investment. The capital is not available unless an expected return occurs.

What else can we learn in these comparisons?

  • The greatest value available to you is those who use the cash flow methodology.
  • Idle assets have value to a buyer using the asset value method, but not the cash flow method.
  • Gross margin matters to value.
  • Putting a tank into service may not increase its value in the eyes of the highest potential buyer, if it is not producing enough income.
  • Because the highest values are paid by the group who use the cash flow method of valuation, you should do all you can to understand what else it is they value.
  • If you assume that what you are doing is adding value – but those who most likely would be the highest buyer for your business do not – are you doing the right things?

Finally, for those of you who live in the opposite worlds of the spectrum in our example of $.05 to $.45 EBITDA per gallon and wonder if the other world is real: It is.

Carl Hughes is vice president of business development for Inergy LP. He can be reached at
Chughes@InergyServices.com
or 816-842-8181.

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