The Past is No Longer Prologue For Valuing Blue Sky in AIADA Summer 2023 AutoDealer Magazine

Auto retailers have commonly averaged the last three years of earnings to estimate expected future profitability. This methodology proved to be an effective predictor of future earnings for the years leading up to the pandemic (see Chart 1). However, beginning in 2020, when earnings commenced their hockey stick progression, the calculus for estimating future earnings based on the last three years of profits started to miss the mark. Buyers and sellers have since struggled to determine future earnings given the seemingly unpredictable nature of the industry post-pandemic. It appears that the past is no longer prologue, and a new methodology for earnings projections is required.

Today, Kerrigan Advisors finds most buyers are eschewing historical earnings in determining blue sky value. As an alternative, many are beginning to project future profits based on their expectations for future profit margins, assuming front-end gross margins normalize at levels higher than the pre-pandemic period, and post-pandemic operational efficiencies are retained. In so doing, these buyers are often averaging historical margins, rather than historical profits, and then applying that average margin to current revenue to project normalized profits for valuation purposes. This methodology often results in a normalized net-to-sales expectation between 4% and 5%. When applying those margins to current revenue, blue sky values range between 3.00 and 8.75 times of normalized profits and between 15% and 35% of current revenue (see Chart 2).

This approach of applying normalized profit margins to current revenue to determine expected future profits and ultimately blue sky is consistent with how Wall Street appears to be valuing the public companies (see Chart 3). Assuming lower net-to-sales levels between 4% and 5% on current revenue, the publics are trading at blue sky multiples consistent with their historical blue sky multiple average.

As with everything since the pandemic, the valuation model for blue sky will continue to evolve as profits normalize in the coming quarters. Kerrigan Advisors believes until the average of the last three years of earnings reflects the expectation for the next three years of profits, buyers will apply their own assumptions on normalized profit margins to current sales to determine the blue sky price they are willing to pay.  How long this new valuation methodology lasts depends on how long it takes for earnings to become more consistent from year to year, whether that is on the way up or on the way down.

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