Example of Use of DMDM to Appraise a Retail Business
Joe and Sam each own a 50 percent interest in Discount Auto Parts, a retail auto parts store. They have agreed to part company under an arrangement calling for one of them to buy the other's ownership interest at fair market value. The buyout is to involve a so called "blind option" under which one of the parties fixes a price and the other then decides whether to buy or to sell at that price. For this reason, the estimate of fair market value needs to be as accurate and unbiased as possible.
Joe has contacted you about appraising the business in order to provide a figure for fair market value of 100 percent of the stockholder's equity of Discount Auto Parts on which to base the buyout price. The appraisal date is December 31, 1997.
Using the transaction data from the IBA Transaction Data Base, together with the information on the following pages, estimate the fair market value of 100 percent of the stockholders equity of Discount Auto Parts, Inc as of December 31, 1997.
Background Information
Discount Auto Parts was incorporated January 18, 1986. Joe and Sam purchased the business from the previous owner in 1989, for a purchase price of approximately $100,000, including inventory.
Joe and Sam operate the business as a Subchapter S corporation.
Discount Auto Parts is located at 985 City Turnpike, Suburbia, USA. This is in a middle class residential community, from which most of the customers are drawn.
There is one other retail auto parts store in the general area from which Discount Auto Parts draws its customers. However, competition is not intense, and there appears to be enough business for both stores.
The store premises are leased from an unrelated landlord under a lease that was renegotiated in 1993 and which expires in November 2000. The store premises consist of approximately 2000 square feet of space. The store includes the customary display shelves, storage space, etc.
Neither Joe nor Sam is active in the business, which is managed by a hired manager. Other store personnel, principally clerks, are employed as needed.
The balance sheet for Discount Auto Parts as of December 31, 1997 is shown below.
DISCOUNT AUTO PARTS
BALANCE SHEET AS OF DECEMBER 31, 1997
Assets
Cash $22,607
Accounts receivable 35,129
Inventory 151,813
Prepaid expenses 6,568
Total current assets
$216,117
Fixed assets:
Equipment $3,503
Furniture & fixtures 24,302
Leasehold improvements 22,456
$50,261
Less accumulated deprec. - 15,387
Net fixed assets
$34,874
Total assets
$250,991
Liabilities
Accounts payable $58,391
Accrued expenses 6,893
Short term notes payable 35,619
Total liabilities
$100,903
Stockholder's Equity
$150,088
Total liabilities and
Stockholder's Equity
$250,991
Summarized income/expense information for Discount Auto Parts for the period 1995 through 1997 is shown below.
DISCOUNT AUTO PARTS
THREE-YEAR INCOME/EXPENSE SUMMARY
1995 1996 1997
Gross receipts $1,023,945 $954,835 $1,136,545
Less cost of sls 675,439 645,654 775,347
Gross margin $348,506 $309,181 $361,198
Operating expenses:
Salaries $113,295 $99,634 $124,267
Advertising 41,437 37,290 37,492
Travel & ent. 2,346 1,212 1,746
Rent 61,437 57,290 65,000
Depr. & amort. 3,625 3,588 3,790
Insurance 7,823 7,467 6,812
Utilities 4,482 4,168 4,842
Professional fees 1,634 1,525 1,981
Office expenses 4,452 3,754 3,342
Payroll charges 21,866 19,229 23,984
Auto expense 4,314 4,236 1,325
Interest expense 1,004 1,537 2,001
Repairs & maint. 3,879 3,234 2,265
Supplies 2,920 1,689 1,745
Miscellaneous 4,343 2,324 5,371
Tot. oper. exp. $278,857 $248,177 $285,963
Net before tax $69,649 $61,004 $75,235
The fair market value of Discount Auto Parts might be determined by using the P/G multiple or the P/E multiple, or by combining the two measures in some manner. Which, if either, of the two performance measures, P/G or P/E, is the more relevant?
Step 1: You have obtained information from the IBA Transaction Database on sales of retail auto parts stores (SIC 5531). If the data was received in hard copy you will need to input the transactions into a spreadsheet program similar to the list that follows.
Next you have prepared the following two scattergrams from the transaction data.
Comparing the two scattergrams visually, it appears that the data points in the selling price to earnings scattergram are more widely dispersed than those in the selling price to gross sales scattergram. This indicates that the selling price to gross sales ratio is a more reliable measure of market value than is price to earnings ratio.
To confirm this impression, a spreadsheet has been used to perform the following calculations:
P/G P/E
Number of transactions 121 42
Mean (average) ratio 0.44 4.43
Standard deviation 0.32 8.72
Coefficient of variation 0.71 1.97
The difference in coefficients of variation confirms the visual impression from the scattergrams that price to gross ratio is the better of the two measures of market value.
It should also be noted that the number of transactions for which price to gross information is available (121 transactions) is substantially greater than those for which earnings information is available (42 transactions). This further supports the choice of price to gross ratio as the measure of market value.
Accordingly, price to gross ratio has been chosen as the performance measure to be used in estimating the market value of Discount Auto Parts.
Step 2: As previously calculated, the average P/G ratio of the 121 transactions in the data base has been calculated as 0.44. That is, the "average" retail auto parts store sold for a price equal to 44 percent of annual gross.
Step 3: Next, the range of values as reflected in the information from the IBA Transaction Data Base needs to be determined. Arranging the 121 P/G ratios in descending order, 10 percent of the values can then be counted off. This done, it has been determined that 10 percent of the auto parts stores sold for a P/G ratio greater than 0.82. Similarly, 25 percent of the sales were at P/G ratios greater than 0.54, 25 percent of the sales were at P/G ratios less than 0.26, and 10 percent were at P/G ratios less than 0.16.
With this information, lines with slopes equal to the various P/G ratios can be drawn on the scattergram. This results in the following graph:
This results in the following graph:
Step 4: To facilitate the next step, the preceding graph can be redrawn, this time omitting the data points which represent individual transactions and adding a vertical line at a position on the horizontal axis corresponding to the annual level of gross revenues which corresponds with Discount Auto Parts. For illustrative purposes, assume future gross revenues of $1,100,000 per year for Discount Auto Parts. This results in the following graph:
The preceding graph can be used as follows:
If, for example, the analyst was to decide that Discount Auto Parts was among the 25 percent most desirable retail auto parts stores, the analyst would follow up the vertical line to where it intersects the line representing the upper 25 percent limit. Then reading across, He could read the corresponding selling price, which in this case Is approximately $600,000 (actually $594,000).
On the other hand, if the analyst was to conclude that the value of Discount Auto Parts is somewhere among the central 50 percent of the market for auto parts stores, the analyst can find the corresponding market values by following the vertical line to where it intersects each of the two sloping lines corresponding to the upper and lower 25 percent limits. By reading across to the selling price scale, it can be determined that Discount Auto Parts has a value somewhere between a minimum of about $275,000 and a maximum of about $594,000.
Step 5: To arrive at an actual estimate of the fair market value of Discount Auto Parts stockholders' equity, a decision needs to be made as to where Discount Auto Parts actually belongs in the range of market values. Also, a determination is needed as to what combination of assets and liabilities typically transfer with this type of sale, and are therefore implicitly included in the price to gross sales multiplier in the IBA Transaction Database.
Where Discount Auto Parts belongs in the range of market values is a matter of the appraiser's informed judgment based on his interpretation of the facts. There are many ways in which this judgment can be aided, a full description of which is beyond the scope of these tutorials.
However, three ways in which the appraiser's judgment can be aided will be described briefly These are:
Study of the historical trend of the business in terms of its probable future performance.
Review of the 1993 through 1997 income statements (the last three years of which have been shown) indicates that sales volume has increased each year of the past five with the exception of a decrease in 1996. Also evident from this information is the fact that annual pretax income has also increased each year except for 1996.
This information indicates that Discount Auto Parts is a relatively stable business operating in a stable environment. It also suggests that, absent any material change in such parameters as pricing and/or operating practices, Discount Auto Parts can be expected to produce results in the future similar to those it has produced in the past.
Comparing the profitability of the business with other businesses of its type.
The analyst can also further compare the financial results of operations against industry standards.
Reaching the final conclusion of value
Assuming for purposes of illustration that Discount Auto Parts was among the 25 percent most desirable retail auto parts stores, and thus determining a $594,000 selling price, the fair market value of the stockholder's equity must be estimated. To arrive at this amount, the appraiser must determine the specific assets and liabilities that transfer in the transactions recorded in the IBA Transaction Database.
Typically (but not always), assets transferred in an asset sale include inventory, fixed assets exclusive of real estate, and intangible assets, or the "book of business."
Given this content of a typical sale of retail hardware stores, then the fair market value of 100 percent of the stockholders' equity of Discount Auto Parts as of December 31, 1997 can be estimated as follows:
Estimated fair market value of inventory, net fixed assets, and intangible assets (content of typical sale): $594,000
Plus cash at December 31, 1997 22,607
Plus accounts receivable at Dec. 31, 1997 35,129
Plus prepaid expenses at Dec. 31, 1997 6,568
Less liabilities as of Dec. 31, 1997 -100,903
Estimated fair market value of stockholders' equity as of Dec. 31, 1997: $557,401
(Rounded to $560,000)
Testing the final value estimate
The $560,000 (rounded) value estimate still needs to be tested by one or more of the methods previously discussed in Tutorial #13.