Whether you’re preparing to purchase or sell a business, one of the most important ways to analyze your investment is to reach an indepth understanding of the value metrics of the transaction. Sellers need to run these metrics to verify their proposed sales price and buyers need to run these numbers to authenticate the value of the deal and – if they are looking at more than one candidate – to compare the values of all the deals they are considering.
The Cap Rate
Determining the Cap Rate is the first step to take in your analysis. This is the process of converting a one-year stabilized net operating income (NOI) of an asset into that asset’s actual market value. Capitalization rate (or “cap rate”) is the ratio between the net operating income produced by an asset and its capital cost (the original price paid to buy the asset) or alternatively its current market value. The rate is calculated in a simple fashion as follows:
Capitalization Rate = Annual Net Operating Income ÷ Cost (or Value)
To do this, we must first determine the Net Operating Income (NOI) of the business. There are many ways to do this, but the most effective way is to subtract from Gross Income all of the relevant expenses, making adjustments for the “extra” perks a seller has taken in order to reduce the profits of a business on paper, as is done when a recasted financial statement is prepared. This subtracted total is the asset’s NOI.
Dividing the projected price of the business by the NOI yields the CAP rate. If the CAP rate is greater than the cost of the cash used to acquire the asset, then a buyer will be able to achieve positive leverage on the investment/acquisition.
Of course, it is important to make intelligent projections about future performance and to forecast the NOI on the buyer’s investment. Intelligent preparation employs this method of analysis to compare multiple acquisitions and determine which may have the best future value by increasing price, reducing expenses, etc.
Cash-on-cash-rates are a simple way of looking at an investment. During the first year, NOI is calculated and then divided by the initial cash invested. A very simple example is an asset where you put 10 percent down; dividing the NOI from the asset by the 10% is a quick method of looking at the performance of the investment.
In investing, the cash-on-cash return is the ratio of annual net operating income compared to the total amount of cash invested, expressed as a percentage.
Cash-On-Cash Return = Annual Net Operating Income ÷ Total Cash Invested
It is often used to evaluate the cash flow from income-producing assets and is generally considered a quick napkin test to determine if the asset qualifies for further review and analysis. Cash-on-Cash analyses are used by investors looking for assets where cash flow is king, however, some use it to determine if an asset is underpriced, indicating instant equity in an asset.
Suppose an investor purchases a $1,200,000 business with a $300,000 down payment. Each month, the net cash flow (gross income less expenses) is $5,000. Over the course of a year, the before-tax income would be $5,000 × 12 = $60,000, so the cash-on-cash return would be
$60,000 ÷ $300,000 = 0.20 = 20%
Internal Rate of Return
Another interesting metric is to determine the Internal Rate of Return (IRR), a projection of the expected rate of growth for an investment used in capital budgeting to measure and compare the profitability of investments. All other things being equal, the investment with the highest IRR would be the one to choose.
This IRR is the percentage earned on each dollar invested for each year it is invested (how can we avoid using “invested” twice?) plus the estimated sales profits. Because the calculation is complex you reach the IRR by calculating the cash invested in the initial year, then the NOI of each future year plus the anticipated/actual sales proceeds after the sale. By completing a five year cash flow model, adjusting it for changes in income and expenses and then determining a future sales price based on anticipated CAP rates, a buyer or seller can use the IRR calculation to predict how the investment may perform.
A smart buyer or seller looks at all the calculations
The measure of success for a merger or acquisition is often the result of the amount and quality of planning that is executed beforehand. Sophisticated buyers will run the numbers through formulas like those described above. Marx Group Advisors always performs these analyses for its buyer and seller and merger clients. In this way, we and our clients are able to look at an established and tested standard of what the market place will bear.
It is not enough to just complete the deal according to financial goals that are set without reference to standard rates of return. A well-designed merger and acquisition strategy will identify why the deal is a profitable undertaking and help position it to be positive for all involved. Asking for help early in this complex process may be the smartest move your company can make.