By: Jay Whitney
In addition to the Multiples Of Earnings valuation method, the Discounted Free Cash Flow DFC) valuation method is also commonly used to value childcare center businesses.
The DFC method is used to determine a business’s ability to generate wealth by estimating the money that the owners will be able to take home with them during the business’s lifespan. To emphasis, we are not talking about profits (profits is an accounting number), we are talking about cash flow to an owner.
To convert future cash flow to today’s currency, a “discount rate” is used to reflect future money’s discounted to today’s value, as well as the risk that the expected cash flow doesn’t happen as planned.
This method is especially useful when there is a substantial difference between the past results and the expected future results as a result of verifiable actions. Examples of verifiable actions:
- A new elementary school is being built next door to the childcare center.
- Large new subdivision(s) are under construction very near the childcare center.
- A childcare center was not managing labor expenses very well. The Owner recently started to manage labor expenses closely and the labor expense, as a percentage of revenue, recently dropped a substantial amount. (For example, labor expense as a percentage of revenue was 55% and had recently been reduced to 45%.)
- Enrollment increased (or decreased) substantially above/below historical enrollment.
- A new competitor is under construction very near the childcare center.
- Tuition prices were recently successfully increased without any decrease in enrollment. If a childcare center’s tuition prices are below what competitors charge, and that center has not put in a price increase in years, if appropriate, the center should put in a price increase before selling the center as a way to increase the value. It is almost impossible to logically convince a potential buyer that the buyer will be able to increase tuition prices while the seller did not attempt to increase tuition prices. (Most potential buyers will not attempt to put in a price increase in the early period of her/his ownership.)
Normally, it is not realistic to present a DFC valuation to potential buyers saying the childcare center is going to have full enrollment when the enrollment has only been at say 75% of capacity in the last few years and there is nothing verifiable that would indicate that the enrollment will change.
Aspects of DFC Valuations of Childcare Centers:
Historical data – Any significant variations should be explained so a potential buyer can understand the cause of the variations and incorporate it into the buyer’s valuation. Without doing this, the buyer’s perceived risk will increase and consequently, the value will decrease.
Future Projections – A financial forecast based on the verifiable actions, along with the projected cash flow and financial structure.
Market Strengths Influence Valuation – Measure of negotiating power of a childcare center business.
- Negotiating power with suppliers – Childcare centers with significant government funding are worth less than centers with exclusively privately paid tuition because centers have no negotiating power with government entities to get higher rates (or prevent a reimbursement rate decline), while centers have very significant negating power with individual parents.
- Negotiating power with customers – A childcare center has very strong negotiating power with parents because parents don’t want to disrupt their children’s education by pulling their children out of one center and putting their children in another center. A childcare center loses that negotiating power with parents when classrooms have recently replaced teachers in those classrooms, or has bad teachers.
This is why centers with long-term good teachers are worth more than centers with high turnover of teachers. When a new owner takes over a childcare center, that new owner has no, or very weak, relationships with the parents. Therefore, teacher turnover during this initial ownership period can affect enrollment much more than at other times.
Competitive position can increase or decrease childcare valuations
- Competitor threats – Childcare centers are worth less during a recession than during a good economy. During a recession, the cost of entry into the market is often lowered because of vacant childcare centers and centers that have significant unused capacity. This drives DFC values down during recessions.
- A childcare business with several centers in a market area can give a childcare business increased pricing power (and value).
- A childcare center business that is a price leader, when combined with full enrollment, shows a strong market position (and value).
What Discount Rate Are Used on Childcare Center Businesses?
The discount rate used depends on how risky it is to buy the childcare center business. As the risk increases, or the size of the business gets smaller, a higher discount rate should be used.
The rates are based on: 1) similar childcare center businesses, 2) transactions that are homogeneous, 3) data that is recent.
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