How Does One Deal with Excess Inventory?
Unlike most comparables sold databases, Bizcomps does not include inventory in the selling price. This is actually a benefit if the subject has excess inventory. Since inventory is not included in the selling price the subject’s inventory must be added to the value indication obtained using Bizcomps. If the subject has excess inventory, this approach will likely overvalue the subject.
For example, assume you are valuing an industrial supply distributor with the following characteristics:
In addition assume that the subject has excess inventory of $200,000 included in the inventory value of $400,000.
If one values the subject, using the median price/SDE multiple from the Bizcomps data on the attached table, ignoring the fact that the subject has excess inventory, the value indication is:
Value = (price/SDE multiple x SDE) + Inventory = 2.25 x 185,000 + 400,000
Taking the excess inventory into account, there are two ways to estimate value.
Method 1: Assume that only the normal inventory required to operate the business would be added back in the above equation, and, then add back the estimated market value of the excess inventory. For the purpose of this example assume that the market value of the excess inventory = 50% of the value of the excess inventory at cost. The value indication would then be:
Value = (price/SDE multiple x SDE) + Normal Inventory + Market Value of Excess Inventory.
= 2.25 x 185,000 + 200,000 + 100,000 = $716,250
Method 2: Recalculate the median price/SDE including inventory (SP’/SDE) on the attached table (assuming that the inventory included in the selling price is the subject’s normal inventory). The value indication in this case would then be:
Value = (SP’/SDE x SDE) + Market Value of Excess Inventory
= 3.25 x 185,000 + 100,000 = $701,250
It should be noted that on the attached table, the coefficient of variation (standard deviation/average) for the SDE multiple including inventory in the selling price (SP’/SDE) is slightly smaller than the coefficient of variation for the multiple that does not include inventory in the selling price (SP/SDE). This indicates that there is less dispersion for the multiple that includes inventory in the selling price, i.e., there is a better fit to the data for this multiple.
The above example shows that a subject may be overvalued if it has excess inventory and the appraiser and/or broker is not aware of this fact and treats all inventory as if it where normal inventory required for business operations. Regardless of whether or not the subject’s inventory appears high compared to industry standards, the appraiser and/or broker should ask the owner if the inventory value on the balance is sheet is realistic, whether the subject has excess inventory, including slow moving or obsolete inventory, and, if the owner can provide an estimate of the market value of the normal inventory and/or any excess inventory.
In the particular example given above, the two methods used to address excess inventory gave similar value indications. This may not always be the case. The appraiser and/or broker should consider both methods and decide which approach is the most reasonable for the subject.
Methods 1 and 2 discussed above work for the Bizcomps database because this database, while it does not include inventory in the selling price, it does provide the value of the inventory included in the sale. Other databases that include inventory in the selling price don’t always show the value of the inventory included in the sale. This makes it more difficult to deal with issues such as excess inventory when using such databases.