Investing in car dealerships: how to value them
Most business valuations are substantially driven by the company’s historical financial statements, tempered by other factors such as: location, brand, management, and more. In truth and fact, the dealer balance sheet represents less than half of the information needed to properly value an automobile dealership. The balance sheet is nothing more than a starting point from which a series of factors must be added and subtracted to determine the true value of the assets.
Valuing new car dealerships is all about projecting future profits and opportunities based on the “dynamics” of the particular dealership being valued and the car business itself.
The Internal Revenue Service recognizes that appraisals include more than financial statements: “The appraiser must exercise judgment as to the degree of risk associated with the business of the corporation that issued the shares, but that judgment must be related to all other factors affecting the value. Income Rule 59-60, Section 3.03.
DEFINITION OF MARKET VALUE
The definition of market value according to the Real Estate Appraisal Dictionary of the American Institute of Real Estate Appraisers is: “The most likely price in cash, cash equivalent terms, or other accurately disclosed terms, by which the appraised property will be will sell in a competitive market under all conditions required for a fair sale, with the buyer and seller each acting prudently, knowingly and in their own interest, and assuming that neither is under harshness”. American Institute of Real Estate Appraisers, Real Estate Appraisal Dictionary. (Chicago: American Institute of Real Estate Appraisers, 1984), 194-195.
In Income Judgment 59-60the Internal Revenue Service defines “fair market value” as follows: “…the price at which the business would change hands between a willing buyer and a willing seller when the former is not required to buy and the latter is not under any obligation to sell, both parties having reasonable knowledge and relevant facts”.
The purpose of Revenue Resolution 59-60 is to outline and generally review the approach, methods, and factors that must be considered when valuing shares of the capital stock of closely held corporations.
The methods discussed in the Revenue Resolution apply to the valuation of corporate shares where market quotes are unavailable or so scant that they do not reflect fair market value.
The ruling goes on to state that no fixed formula can be devised for determining the fair market value of closely held shares and that the value will depend on such considerations as:
(a) The nature of the business and the history of the company since its inception.
(b) The economic outlook in general and the condition and outlook of the specific industry in particular.
(c) The book value of the shares and the financial condition of the business.
(d) The company’s ability to generate profits.
(e) The ability to pay dividends. The ability to pay dividends is often more important than the history of distributing cash to a company’s shareholders, especially when controlling interest is valued.
(f) Whether or not the company has goodwill or other intangible value.
(g) The sales of the shares and the size of the block of shares to be valued.
(h) The market price of the shares of corporations engaged in the same or a similar line of business whose shares are actively traded in a free and open market, either on a stock exchange or over-the-counter. With respect to the sale of an individual dealer, the best comparable is the amount the public company paid or received to buy or sell a similar dealer, not the public company’s stock value or multiple of earnings, per se, which is reflected in the stock market.
In practice, several different formulas have been used to arrive at a new car dealer’s fair market value:
1. ROI Formula (or Earnings Valuation): The value of a business to a particular buyer based on ROI analysis. This value varies from buyer to buyer, based on the buyer’s investment criteria, and may or may not reflect fair market value. The National Automobile Dealers Association (NADA) refers to this value as “Investment Value.” A Dealer’s Guide to Valuing a Car DealershipNOTHING June 1995, Revised July 2000.
The capitalization rate is determined by the stability of the dealer’s earnings and the risk involved in the car business at the time of sale, investment or valuation. This method is highly subjective as the cap rate is based on the particular appraiser’s perception of business risk; Consequently, the lower the risk the appraiser perceives, the lower the cap rate and the higher the price he expects a potential buyer to pay for the business.
In short, the cap rate is the appraiser’s opinion of the rate of return on investment that would motivate a prospective buyer to purchase the dealership. Considerations include those specified in Revenue Resolution 59-60, as well as the available rate of return on alternative investments.
2. Adjusted Net Worth Formula: Net worth of the company, adjusted to reflect the appraised value of the assets used in the daily operations of a business, assuming that the user or buyer will continue to make use of the assets. Blue sky or goodwill, if any, will be added to this “net worth” value. The “adjusted net worth formula” is the most common method used to buy and sell a new car dealership.
3. Orderly Liquidation Formula. This method values the assets as if they were all to be sold, not in a “fire sale,” but in an orderly manner without time constraints. Normally, if the dealership is profitable, some value will still be placed on the goodwill.
4. Forced liquidation. The lowest of all values, forced liquidation means that all assets must be sold in a forced sale, such as an auction, a creditors’ sale, or by order of a bankruptcy court. A bankruptcy proceeding involving a new car dealer almost never generates goodwill. This could be the most appropriate formula if the concessionaire does not have a lease (or only a short term remains on its lease) and cannot, in practice, relocate.
5. Income Formula. The revenue formula basically takes the store’s earnings and multiplies them by an appropriate cap rate. The trick here is the definition of “earnings”. To determine “earnings,” a prospective purchase could use any combination of the following:
(a) current earnings
(b) average earnings: add up the last five years and divide by 5
(c) weighted average earnings: usually a reverse weighting with the current year times five, last year times four, year before last times three, four years ago times two, five years ago times one, then adding and dividing for 15
(d) cash flow: net income plus agreed-upon add-ons such as depreciation, LIFO, personal expenses, excess bonuses and others
(e) forecast earnings – projected future earnings discounted to present value.
6. Fair value. NADA also refers to a third value besides “Market Value”, “Investment Value”, which it calls “Fair Value”. NADA describes “Fair Value” as “…used primarily when a minority shareholder objects to a proposed sale of the business when assessing liquidated damages.” and defines it as: “The value of the minority interest immediately prior to the transaction to which the dissenter objects, excluding any appreciation or depreciation anticipated in advance of the transaction and without reference to a minority or non-marketability discount.”
The NADA guide states: It is not common for car dealers to come across this particular valuation standard. this author has never used, nor have you ever seen this value used in regards to car dealers valuation.
As can be seen in this report, this author in discussing valuations excludes what NADA describes as “Fair Value”.
7. The Biggest Fool Theory. The publication of the National Association of Automobile Dealers (A Dealer Guide to Valuing an Automobile Dealership, NADA, June 1995), baffles, in part: “A rule of thumb is more correctly known as a ‘biggest fool theory.’ However, it is not a “valuation theory.” on sound economic or valuation theory,” but advises sellers to “go for it, and someone might be stupid enough to pay [it].”
The considerations for valuing new car dealerships are more complex than those used to value most other businesses. Dynamics such as the unique requirements of car manufacturers and dealers can limit the amount of money that can be paid by a dealer, regardless of the perspective that clients may offer to pay for the store.
Therefore, the value of a new car dealer varies according to the needs and ability of the buyer, and consequently the same dealer could have two different values for two different buyers and both values would be correct.
Therefore, our valuation of the dealer in question must be considered in the context and limitations of the facts and history of new car dealership sales as described herein.
