Why Won’t a DCF Valuation Compute (Probably) For Your Small (SMB) Business, What Does It Have To Do With The Terminal Value And What Can You Do About It?

Why Won’t a DCF Valuation Compute (Probably) For Your Small (SMB) Business, What Does It Have To Do With The Terminal Value And What Can You Do About It?

by | Nov 14, 2023

In two recent valuations I created – the first for a growing beauty suite rental business and the other for a very successful Las Vegas-basedTanning Salon – I discovered a very interesting phenomena – DCF doesn’t work.

Technically, of course, you can use a spreadsheet, some assumptions and a bit of math and create a DCF. You can even create an extremely conservative one (super high WACC of ~15%, super low Terminal Growth of 1% or even less) – and still, for relatively successful small businesses, at least based on the sample of two – DCFs just don’t work.

In other words, even the most generous multiples based on the most generous comp reviews will result in a valuation significantly lower than a conservative DCF. While this phenomenon did not appear to be the case with struggling businesses, DCF did not appear to work for two successful small businesses, which begs the question: what does this mean? Let’s attempt to answer this question by analyzing the beauty suite Rental business and the tanning salon business.

For the Las Vegas tanning business, I used an average of 31% CAGR, which was lower than their previous multiple-year growth, a conservative 13% WACC and a 2% Terminal Growth.

On the other hand, based on applicable comps, I created a weighted comp average to compare the tanning business with similar US businesses as well as LV-based luxury beauty services. The revenue multiple was 103% and 181% respectively which yielded the following:

As you can see, despite being conservative on the DCF and liberal on the comps, the DCF still came out at a much higher valuation than that of the comps.

However, had I decided to omit the Terminal Value (despite it being conservative, according to Damodaran), the results would have been completely reversed:

In other words, it is not the 31% growth that created this lopsided valuation, but in-fact the terminal value, at [Y6 FCF / (WACC-TG) ] .

The beauty suite business case was very similar. Again, we were confronted with a fairly successful and growing business, using a forward growth rate of 13% but even more conservative assumptions for our Terminal Growth at 14.2% WACC and .5% Terminal Growth. For our Comp multiples, we used a weighted average of SDE, Asset-based and Revenue comps and came out with numbers of around 176% of sales and 288% of SDE (You’re right – this is a low COGS business) which is definitely higher or more liberal then what various internet publications would tell you. Yet, again, despite being ultra-conservative on one side and ultra-liberal on the other – here are the results:

Again, the ultra-conservative DCF is much higher than relatively generous comps. And again, if we remove the Terminal Value (The one with the high 14.2% WACC and the low .5% Terminal Value) from the equation, we get very different results:

In very simple math, this is almost inevitably true:

Based on rough assumptions from here, on average, the FCF to Earning ratio is roughly 92%, assuming the following:

  • First Year Revenue of $1,000
  • Average Small Business profit margin of 8.5%
  • As mentioned previously, FCF to Earning ratio of 92%
  • An average Sales multiple of .62 and an SDE multiple of 2.44 (Based on BizBuySell data)
  • Based on Damodaran data, WACC, on average, should be at no more than 11%
  • Small businesses should grow at a higher than 8% rate; inflation is below 2% on average – we use a conservative assumption of 5% YOY growth
  • For the Terminal Value, we are using an even more conservative assumption of just inflation, at around 1.9%

The results are clear – a classic DCF yields a much higher valuation than either comp does. However, a DCF that does not take Terminal Value into consideration is more aligned with the average of the other comp methods.

The results therefore of both my real time examples ,as well as that of our back of the envelope calculation using agreed upon averages is the same – a DCF produces significantly higher valuations for decent growth businesses than comps do.

We proved that DCFs yield a higher valuation than do Comps.

What can be the possible reasons?

I would like to suggest three possible answers:

  1. Cost of Debt
    Terminal Value is a construct, at least for some businesses. No one can really foresee the future in a high turnover environment, and even more-so in a high Cost of Debt environment. You see, Cost of Debt is not just a component of WACC but an actual business deterrent. The fact that the average lifetime of a small business is no more than 8.5 years, contradicts the very notion of a terminal value, and in fact, deems it meaningless.
  2. Competition
    Only 30% – 40% of businesses actually sell. BizBuySell has an inventory of 65,000 businesses, but only reported 2,281 businesses sold in Q3, 2021. Sellers are eager to sell for a multitude of reasons, including retirement, high rent rates or deciding to go corporate. Buyers on the other hand are abundant (3.5M visits on BizBuySell every month) as the very best opportunities offer truly lucrative deals; however – ultimately this means that the market for small businesses is very much a buyer market, and will probably always be. 
  3. High Risk of Failure
    Whereas many large companies or enterprises are considered to be “too big to fail” (although, tell that to Credit Suisse or Blackberry). With 20% of small businesses failing in the first year, and 50% failing in the first 5 years – this is a real risk. Although, one would think it doesn’t pertain to the examples set above of fairly successful, albeit small and at least in one case (the tanning salon), still fairly new businesses. This goes back to any growth assumption and definitely hurts any Terminal Value assumptions by definition.

    As with the stock market, a DCF, at least for a small business, should be based on an expected yield (growth X risk) and not just growth assumptions alone. This is usually done via the WACC; however, the smaller the business, the riskier it is, and this might mean you have to double the Damodaran average WACC. And indeed, lo and behold what happens in the example above with a 22% WACC, instead of an 11% one.

Suddenly it’s the Sales multiple that is so much higher than anything else, whereas the DCF actually can serve as a reasonable weighted average valuation.

So, what does this mean to you?

As a potential buyer, cruising BizBuySell for the right opportunity, this means that if:

  • You have specific small business management experience, or else, are just extremely confident in your ability to manage anything for greatness.
  • You search the stacks of hay on BizBuySell or LoopNet to find the few needles – the truly growing businesses with strong financials, a great track record, loyal customers, and a positive employee turnover rate. Your due diligence has to be spotless.
  • The current owner has a REALLY GOOD REASON to sell (e.g., he’s 85 and he’s moving to another country) – AND the business does not require his presence to succeed (unlike this business where an 85-year-old French baker baked in his French bakery and just wanted to retire at home)
  • You do a DCF, and despite the competition – the business is still priced below.

Then potentially, you can buy a great business for a fraction of what it would have been worth had it not been a small business, like… Kodak
Or Blockbuster.