The Importance of Reasonable Expectations

From time to time in this space, we have presented articles discussing the various factors that influence the value of a company. In addition, we have stressed to business owners the importance of understanding these value influencing factors especially with both the general economy and the acquisition market currently in the middle of what will hopefully be sustained recoveries. This is certainly necessary for owners who are currently considering the sale of their business or may consider such a transaction in the near future.


Before we begin, we caution business owners to have reasonable valuation expectations. One of the most important roles that we at Mercer Capital play as transaction advisors is to assist owners in the development of pricing expectations. Through this role, we have witnessed the difficulty that many business owners have in taking an objective view of the value of their company. In many cases, it becomes a highly emotional issue, which is certainly understandable considering that many business owners have spent most of their adult lives operating and growing their companies. Nevertheless, the development of reasonable pricing expectations is a vital starting point on the road to a successful transaction. Almost without exception, a lack of reasonable expectations results in a selling process that is frustrating and most often disappointing to the selling party.

The development of pricing expectations should consider how a potential acquirer would analyze your company. In developing offers, potential acquirers can (and do) use various methods of developing a reasonable purchase price. Most fundamentally, an acquirer will utilize historical performance data, along with expectations for the future, to develop a level of cash flow or earnings that is considered sustainable going forward. In most cases, this analysis will focus on earnings before interest, taxes, depreciation and amortization (EBITDA) or some other pre-interest cash flow. A multiple is applied to this sustainable cash flow to provide an indication of value for the company. Multiples are developed based on the underlying risk and growth factors of the subject company.

Cash Flow/Earnings

As mentioned previously, before a multiple can be applied in determining value, a company’s level of sustainable cash flow or earnings must be developed. During the economic boom that ended in 2001, this was typically not difficult because most companies were growing at relatively predictable rates (predictably high rates for most). Sustainable cash flow was either the most recent year’s cash flow or the projected cash flow for the upcoming year. However, recent uncertainties have made this determination substantially more complex in many cases.

Two questions that will likely be asked by an analyst upon initial review of a company’s recent performance are: What is a company’s sustainable cash flow following two or three years of decline from its peak year? What about if the company capitalized on the recent economic improvements and posted a nice turnaround during the most recent year? For many companies, performance during the past few years has been below that of the late 1990s. Some companies have begun the process of turnaround in posting positive earnings growth during 2003. So what does all of this say about a company’s sustainable level of earnings? The answer is, as with most valuation related questions, it depends on the specific operational and financial circumstances of the company. The variables effecting the development of ongoing earning power are obviously too numerous to list in full here, but in general these variables are the same variables that most owners track (or attempt to track) on a regular basis:

  • Growth or decline in the market for the company’s product(s)
  • Growth or decline in market share
  • Increase or decrease in pricing power
  • Increasing or decreasing trend in margins
  • The competitive landscape


Recent fluctuations in performance (especially those trending downward) also affect the multiple applied to the sustainable cash flow. While risk and growth characteristics are the underlying determinants of multiples, various other factors are considered by acquirers. These include:

  • The amount and terms of available financing for the acquirer
  • Any strategic or synergistic considerations for the acquirer
  • The multiple at which the public market has priced the shares of the acquiring company (in a transaction involving a public company)
  • In addition to the above, the multiple is developed in the context of the sustainable earnings figure discussed above. If improvements from recent years were assumed in the sustainable earnings calculation, then a somewhat lower multiple may be applied. If a recent year of low cash flow is utilized as the sustainable figure, then a higher multiple may be paid based on the expected improvements from the base figure

So, what is the appropriate multiple? Again, the answer depends on the specific characteristics of the subject company.

Parting Thoughts

This article clearly does not provide a complete discussion of the various factors that impact value. It is meant primarily as a reminder that thinking about these issues is important for all business owners, regardless of situation. The goal of sellers in all transactions is to maximize the consideration received for that which is given up.

Our experience at Mercer Capital has proven time and again that the most positive outcomes are generally achieved by sellers with reasonable expectations developed through a thorough examination of the specific circumstances and characteristics of the subject company.

If you would like assistance in developing a detailed valuation analysis of your company, or if you are considering a potential transaction, please contact us at 901.685.2120.

Reprinted from Mercer Capital’s Transaction Advisor – No. 1, Volume 7, 2004.

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