Do you add total inventory cost to the purchase price of the business?

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March 28, 2020

by a searcher from Cornell University - SC Johnson College of Business in Providence, RI, USA

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Reply by an intermediary
from Naval Postgraduate School in Bellevue, WA, USA
Not necessarily. Usually inventory is included in the assets purchased. I initially look at the return that that is expected from the free cash flow divided by the purchase price. Given the risks of owning an il-liquid business with normal dependencies on the economy, key employees, etc.. a new owner should expect that the company will return at least 25% on a forward looking basis. This translates to 4X looking forward and perhaps 3x looking back. Assuming a reasonable multiple, adding back the inventory will result in an unfavorable expected return. . I have seen some distribution companies with very large and valuable inventories but under close analysis the inventory is not turning per industry standards and includes many line items that have to be discounted because there are slow moving.
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Reply by an intermediary
from Wake Forest University in Winston-Salem, NC, USA
It depends. If you are looking at a comparables database, it also depends on the specific database that you are using and how they handle the inventory (and working capital) in the numerator (price paid). For instance, BizComps explicitly excludes the inventory value and working capital from the Purchase Price, so you have to add the inventory to the product of multiple and SDE/EBITDA. PeerComps includes a "normalized level" of inventory in its Purchase Price definition and value, but explicitly excludes other working capital. DealStats (fka Pratt's Stats) includes inventory and working capital for the most part, but it can vary by transaction and industry, so you have to look at the detailed report for each comparable used.
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