Comment On Valuation - November 14, 2016
COMMENT ON VALUATION FROM NOVEMBER 4, 2016 ARTICLE
As always, thank you for the amazing contributions you make in virtually every facet of the industry. You are truly an industry treasure. By the way, my partner Steve Rubin wrote you last week, and mentioned my book, "THE START OF THE DEAL", and within a few hours of publication, we had already received 25 orders from your readers for the book. Even though it was free of charge to your readers, it's a amazing testimonial to the power of your newsletter.
In your November 4 newsletter, in the letter entitled VALUATION OF ALARM COMPANY, you commented that the reader was coming up with an evaluation based on the combination of EBITDA and RMR. You then went on to suggest that it was either one or the other, but not a combination. Actually, that may not be entirely correct. I believe we have pioneered a methodology by which we can help a dealer who has a traditional alarm company and has, in addition, built up a integrator business, pretty much separate and apart from the alarm business. In that case, we develop a fair price for the RMR (using a multiple of RMR) in addition to which we add a multiple for the EBITDA. It's like having two separate and distinct divisions of the same company. It takes a pretty knowledgeable industry accountant to be able to make the correct allocations, but once done, allows for a fair and equitable price for the company.
What we are seeing in the marketplace is that RMR for traditional residential alarm systems is not increasing by very much, and in some cases is being impacted negatively by low-price marketers and DIY programs. Consequently, many alarm companies are shifting away from residential and embracing a commercial business model. Seems to be working. Just a thought for your readers to be thinking about.
Again, thank you for all that you do for the industry. Best,
Davis Mergers and Acquisitions Group, Inc.
AKA "the Graybeards"
Cell. 1 847 910 7716
Your comments are, as always, on point and appreciated. Valuation of an "alarm business" can involve more than the RMR times multiple method, and when the alarm company has transitioned into a home automation and integration operation the EBITDA method would be appropriate. Esentially, as you point out, we are valuing two different operations, even though owned by one company. This is also an issue when traditional alarm companies have "per call" service or inspection revenue that is not RMR.
I am surprised by your remark that DIY is negatively impacting the residential monitoring market. I actually think that is going to prove very wrong. In fact I think the DIY sale with monitoring is going to increase the residential monitoring market. Though some DIY systems are DIY monitored, most programs offer professional monitoring service, and that affords alarm companies the opportunity to charge RMR for monitoring. May be less than the traditional monitoring charge, but the investment in getting the subscriber should be less and there is potential for many more subscribers.
Lots of DIY programs coming out that alarm companies can hook up with. Keep your eyes open.
ANOTHER COMMENT ON VALUATION
Responding to the question in today’s article [Nov 4 2016] about the value of a security company in which the stockholder wanted to use both a P&L multiplier and a multiple of RMR. Your answer that he can’t essentially “have his cake and eat it too,” was spot on, but let me elaborate a bit on this.
Alarm companies are typically valued using a formula of Recurring Monthly Revenue (RMR) because the buyers of RMR are not necessarily interested in the profitability of the selling business as a whole. They have their own infrastructure, monitoring costs, service costs, etc… and are simply considering the effect that a stream of cash flow will have on the purchasing company’s future earnings. For example a buyer with its own central station may have an incremental monitoring cost of $2 per account, so the fact that a seller may be paying $4 per account has no bearing on the profitability of the account base in the hands of the Buyer. When other factors such as economies of scale and the elimination of redundant management (along with the termination of the lease on the Seller’s Cadillac) are taken into consideration it is much more reliable to value the RMR component of the selling company by a gross multiple.
The second approach which your reader calls the “P&L Multiplier” is similar to the Income Approach (utilizing the Capitalization of Earnings Cash Flow Method) used by Valuation Professionals. When we do a formal Valuation in a situation such as a divorce, partner dispute, or secession planning, we consider various approaches. The Income Approach rarely results in a higher value than simply valuing the RMR and net assets (Asset Approach). Occasionally we will encounter a large systems integrator with a small RMR base but sales in the millions. In these cases we use a hybrid approach in which we determine a value of the RMR, subtract the net cash flow that results from the RMR, and value the business based upon the remaining earnings before income taxes, depreciation, and amortization (subject to some adjustments). We then add the value of the RMR at a multiple, to determine the net value of the business. This may sound a little complicated, but it is, in fact, very complicated. Simply applying a ‘multiplier’ to a net income number is much too simplistic.
For the majority of security companies, the highest value will be obtained by multiplying the RMR by a multiple. The question here is… what multiple? An established Fire Alarm company with profitable installations and low attrition will sell for a much higher multiple than a mass market company with high creation cost and high attrition. Again Ken is spot on when considers these factors in his valuations. Reputable brokers can also give you a great idea of marketplace trends and what they would expect a Buyer to pay for a given company. Back in 1959 our friends at the Internal Revenue Service issued a Revenue Ruling (RR 59-60) in which they defined Fair Market Value as “The price at which a property would change hands between a hypothetical willing buyer and a willing seller, both being adequately informed of the relevant facts and neither being under any compulsion to buy or sell.” This is how Ken and the brokers on his Exchange approach valuation of Security Companies.
If you are selling your security company, Ken, as well as any of the experienced brokers on The Alarm Exchange can help you. If you need a complete valuation for a divorce, partner dispute, S Corporation Election, or any situation in which there may be dispute, whether from the other party or from a third party (think IRS) we can help you. I am a member of the AICPA and of its Forensic and Valuation Services group and can prepare a valuation that will hold up in court, in fact, most of our valuations effectively end the dispute that had both parties on the road to the Courthouse in the first place.
Reitman Consulting Group
5408 Woodway Drive|Fort Worth, TX 76133 | 817-698-9999 o | 817-698-0009 f