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Putting A Price Tag On A Hog Business

You might be looking to buy. Looking to sell? Trying to show your lender your credit-ability? Putting together an accurate net worth statement?Always the big question about a business is, what's it worth?There are several traditional ways to put a price tag on a hog business. Most center around putting a value on buildings, equipment and animals. Generally, little or no attention is paid to the management

You might be looking to buy. Looking to sell? Trying to show your lender your credit-ability? Putting together an accurate net worth statement?

Always the big question about a business is, what's it worth?

There are several traditional ways to put a price tag on a hog business. Most center around putting a value on buildings, equipment and animals. Generally, little or no attention is paid to the management behind that business.

The "capitalization of earnings" valuation method, although not new to many businesses, is relatively new as a useful tool for farmers.

Instead of just looking at the value of the hard assets in a business, it considers management, explains Lee Fuchs, Senior Lending Officer with AgriBank FCB in St. Paul, MN. An important part of the formula is profit.

How It Works At first glance, the capitalization of earnings approach to valuing a business may seem a little complicated. But stick with the explanation, you'll see the advantage it can have over other methods.

Half of the equation is your annual earnings, net income from the business. Use an average for the last five years, Fuchs explains.

The other half of the equation is called a "multiple" because, once you determine what it should be, you multiply your average earnings by it to get the market value of your business.

The multiple is somewhat subjective because whoever rates you is making judgments. You, in fact, may make that judgement. You rate the industry and the business management on a scale of 1 to 10 with 1 being very high risk, 10 being low risk.

"Volatility is a big part of it," says Fuchs. "Volatility is hog prices that can range from $10 to more than $60 in less than two years. My opinion of the hog industry is that it warrants a 2 or 3 on that 1 to 10 scale."

The theory is that an average risk of all businesses, everywhere, is meant to be a 5. A grocery store that experiences a pretty stable economy and that can raise the price on orange juice when the Florida groves freeze might be rated near the upper end of the scale, for example. A feed company might rate a multiple of about 5 since it is usually about average risk, says Fuchs.

But not all hog operations are equal. So you must evaluate each individual operation. "A producer who is better than average in his industry for managing risk could end up with a multiplier rating of 5, for example," explains Fuchs.

A Producer Comparison Start with producer A who has $300,000 of debt on his facilities. His average earnings over the last five years are $100,000. He has an average production system and sells totally on the open market. His employees aren't especially well trained, just kind of average. Pig flow is a little sporadic.

"Under that kind of system, we know the earnings are likely to be very volatile," says Fuchs. "You might find his earnings for the 5-year average ranged from a loss of $20,000 to a profit of $150,000.

"We would probably rate him as a 2," Fuchs adds. "Therefore, the value of that business, buildings, equipment, hogs and all would be about $200,000 ($100,000 average earnings x 2) plus the amount of debt, or $500,000. A buyer might pay $200,000 and assume the debt."

Now compare that to producer B. He also has $300,000 of debt on his facilities. His average earnings are $70,000. But he is selling to a packer under a cost-plus contract rather than on the open market so he takes no market risk. He has a well-trained labor force that would go with the business. He has good, all-in, all-out pig flow and utilizes segregated early weaning (SEW).

"You look at all those things that stabilize earnings," says Fuchs. "He is more consistent in turning out pigs because he has less disease and other problems that interrupt pig flow."

In fact, his range of earnings might be about $60,000 to $80,000 over the five years used to average.

"His multiple might be more like 5," says Fuchs. "Therefore, his $70,000 average earnings times the 5 multiplier says his business is probably worth about $350,000 plus the $300,000 of debt, or $650,000 total. That makes his business worth about $150,000 more because of stability."

The key to accuracy with this valuation method is determining the correct multiple.

In other industries, multiples are set by people who observe the industry and help other people buy companies.

In agriculture, nobody officially sets multiples at the present time, says Fuchs. However, some lenders are using the 1 to 10 scale to assess how much risk their customers are taking. They likely use the result as part of the lending decision.

"Lenders are still going to use book value and market value as the basis of most lending decisions," says Fuchs. "But when we see producers who appear to be too highly leveraged but profitable we will look at how they are running their business before automatically saying no.

"We might say we don't like your book value equity but we will still loan you money because we think there is hidden value in your business because of the stability," Fuchs explains.

Although the "capitalization of earnings" approach to putting a market value on a hog business holds some excitement, AgriBanks' Lee Fuchs suggests you run through one or two other options before you buy or sell.

Book Value Approach This method starts with the original cost of buildings and equipment. If you have made major improvements (not repairs), add the cost, then subtract depreciation.

The result should come close to the value of the buildings and equipment. Subtract any debt to get your net worth in those assets.

When Fuchs talks depreciation, he means a dollar amount based on how fast those buildings and equipment get used up. That's different than income tax depreciation in most cases.

Common guidelines are that hog buildings will wear out (depreciate) over 20 years and equipment over about 10. But if you figure to bulldoze the building after 15 years, that's the rate you ought to use. That is, depreciate 1/15th of the original cost per year.

The key with this method is to value assets based on Generally Accepted Accounting Practices (GAAP), says Fuchs.

If you are valuing the whole business, book value is going to take care of buildings and equipment. You would usually use market value to determine what the animals are worth.

A drawback of the book value approach is that it usually won't factor in market conditions. In today's depressed market, for example, book value is likely to be more than you could get for those assets, says Fuchs.

Market Value Approach An independent appraiser looks at your business and determines what it would sell for. The valuation can include buildings, equipment, animals and even feed inventory. Subtract debt and that would be your estimated market value net worth.

This is the appraisal method most people use when preparing to sell the facilities or the entire business.

"A drawback is that you're depending on a specialized appraiser who is supposed to know the industry," says Fuchs. "Get the wrong appraiser and you can get a bad value."

One advantage to this method is it does take into account the market conditions. That can be an advantage now, if you're the buyer.

Another advantage is this method can take into account the quality and upkeep of the assets, says Fuchs. For example, even in a depressed environment, the buyer may recognize the buildings as state of the art, therefore, he may add some value for high quality and good upkeep.

A real good appraiser might look at your production and financial records and factor those into the value. But many will only look at the physical assets, Fuchs adds.

If you know of a good, modern hog facility that has actually sold (not just a rumored sale), Mike Morris would like to hear about it.

He's a Senior Certified Appraiser for AgriBank at Champaign, IL. Appraisers depend on actual sales to help them determine the market value of buildings and equipment, he explains.

"I've talked with 10 to 20 appraisers across the Midwest and everyone says they are going on gut feel right now because there are no sales to really test where this market is," says Morris. Rumors abound. "Like the one about a producer who has had facilities for sale at what would have been a good appraised value six months ago and they're not even getting any lookers.

"There has been one sale of a large facility in the Midwest recently," he adds. "Everybody in the appraisal business is anxious to get the details because this is the first modern, sizable facility we know of to test the market since about August."

Morris, however, isn't looking for a lot of sales. He encourages producers who can hold out to not over-react.

"When things hit bottom, everybody seems to want out whether it's the land market, the stock market or the hog market," he says. "Then, when it starts coming back and hitting the peak, everybody wants back in.

"If you're bleeding financially, you may not have an alternative," he adds. "But it appears this thing is going to turn around in the next few months and become more stable."

Whether you're the potential buyer or seller, Morris has some insights that might help.

There is a good market for hog businesses if you have a production contract with a good integrator because it's an opportunity to buy that income stream.

Also, there's still good demand for "modern type facilities that are sized appropriately." Because the price recovery is probably going to be gradual, there could be some discounts on those, Morris believes.

"I don't feel there will be massive sell-off of those kind of facilities," he says. "There might be a 20-35% discount for some facility types, depending on where they are located and how hard-pressed the seller is to get out."

He's referring to a discount after normal depreciation. A 2-year-old facility, for example, would have about 10% depreciation off the replacement cost to start with. Then plug in the discount for a depressed market.

While his job is to strictly look at the buildings and try to put a market value on them, Morris has seen a real difference in value of vacant buildings vs. those in full production.

"When that facility is in production and has good management, I have seen them sell for as much as 20% more than what the buildings would appraise for if they were empty," he says.

His advice to sellers - look at what you have to offer that might make that asset worth more. Contracts, location and a labor and management team can be worth a lot.