General
Valuing a business can be one of the most worrying parts of selling and also conversely for a potential buyer, of purchasing an existing business. Whilst a seller will not be prepared to sell a business for less than its perceived value to him or her, if you look at it from a potential buyer’s point of view, there is probably no part of the buying process that worries them more than a perceived overpayment for a business. Whilst this is very understandable, this has more to do with misinformation and the total approach to the task than it does to being an expert at appraisals. You will not be surprised to learn that there are no precise ways to value a business. The seller will always strive to increase the price whilst potential buyers will want the opposite. Put simply, the truth is that the value of a business is completely subjective. After all, what one business may be worth to one person is entirely different from what it is worth to another. Whilst there are many cases where people may not negotiate the best price possible for a good business it must be understood from the buyer’s point of view that no price is cheap enough, if they were to buy the wrong business. In time, a good business will always justify the purchase price whereas a bad one could possibly never allow the buyer to recover financially. The value placed upon a business will always be a measure of what a buyer can get in return for the purchase price.
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So, the worth placed upon a business can be determined primarily by how much profit a potential purchaser can make from it, balanced with the risks involved in acquiring and running it. Historic profitability and asset value are only the starting points in valuing a business. Any intangible assets such as there may be and these could include any one of the following list: patents, trademarks and intellectual property rights, trade licenses, together with goodwill and reputation, key business relationships, reputation, niche placement in the market. Any of these factors may well increase the value placed upon a business. One of the main reasons for valuing a business is to help the owners or potential owners of a company to sell or buy it. By understanding the basic mechanics of the often complex valuation process, there will be a better chance of a sale being completed if both the seller and buyer start the discussions with realistic expectations.
The price that you may end up selling the business at can also vary greatly depending on such factors as its location, the industry time of year when the business is being sold and the economic cycle. Clearly a potential buyer may be more cautious when buying a business during an economic downturn.
A business is only worth what someone is willing to pay for it. Many smaller business owners grow quite attached to their businesses and very often value them at levels higher than industry conventions would otherwise dictate. So you must be realistic about the true value of your business before offering it up for sale. And please remember to always seek good professional advice before you do.
The types of business that may require a valuation include
Private limited companies, maybe even some public limited companies if they were registered in the early 1980’s, partnerships – including those with limited liability, sole traders and professional practices etc.
When a business valuation is needed
To help sell or buy a business
By better understanding the valuation process involved, there is a higher probability that a sale can be completed efficiently and therefore more speedily and cost effectively.
It can also help in the negotiations for better terms.
It can also be used to identify how a business’s real or perceived value can be enhanced.
A valuation can also help to sell and buy shares in a business at a fair price
And similarly, it can also assist in the agreement on a price for any new shares that may be issued in order to raise fresh equity capital.
Valuations can identify poor performing divisions in a business
There may be a part of the business that is not performing as well as other parts. A valuation could focus management on important key issues and identify those areas of the business that may need to be changed.
Management motivation
Valuations can provide a measurement and incentive for management performance. It can also be a good discipline if undertaken regularly.
The basic factors that can influence the value of a business
The reasons for a valuation
A forced sale will inevitably drive down the value of a business, for example because of the unexpected ill-health of an owner. If a sale is forced, any valuation methods could end up being discounted to encourage a quick sale. You may not be too surprised to know that Her Majesty’s Revenue and Customs can have an influence on an urgent requirement to sell a business if there is a large tax bill pending!
With the winding up of a business, the value placed upon it will be its net realisable assets.
The sale of a part share in a business perhaps in order to raise capital for instance can also influence the valuation.
The tangibility of business assets
A business which owns land and buildings, machinery and equipment etc. has tangible assets. There are relatively easy ways to value these parts of the business. However, some businesses can have virtually no tangible assets except some items of office equipment, fixtures and computers. In this case, such a business’s value would therefore be in its potential future profit streams.
How intangible assets can influence the value of a business
The most important source of value in a business may be something which is not easy to measure accurately. Some businesses may have intangible assets such as goodwill and intellectual property rights that may, or more likely may not, be recorded in the balance sheet at their true value. As referred to earlier, reputation of the business and strong relationships with key customers, licenses to manufacture and distribute successful products, niche market positions etc. can all add value to a business. Also don’t forget the quality and stability of a business’s management team. The more risks there are from a buyer’s point of view, the lower will be the perceived and therefore negotiable value for the business. However, intangible assets are notoriously difficult to value, but there will have to be some kind of valuation undertaken to ensure that the business is valued at its full and fair potential. In many cases, however, it will come down to how keen a potential buyer is to acquire the business.
The age of the business
The age and maturity of the business can also influence a valuation. A young business may have negative net asset value and may be making losses but may have a bright future in terms of forecasted profitable revenue streams such as maybe the case with High Tech or IT businesses.
The Main Valuation Methods Available
Asset Based Valuations (Total Net Assets)
This method of valuation is more appropriate for established stable companies with a large stated net value of tangible assets. Property companies would certainly be included here and even some manufacturing businesses would be a typical example as well. The value would commence with a review of the quoted net asset value of the business and then by considering the actual perceived net realisable value of all company held assets. With some manufacturing companies the total value of all its fixed assets could represent a very large proportion of the total company net assets, with land and buildings accounting for much of this.
However, take note that property could be over or undervalued in the balance sheet. Although there is a recognised accounting standard for depreciation of buildings, some small companies do not always follow this procedure. Also commercial building values (although not necessarily land values) have fallen considerably and in some cases by more than 20% in the last 5 years. So it will be essential to obtain a current valuation on any properties owned by a business. Also many business assets such as plant, equipment and vehicles may be worth a lot less than the depreciated net book values if you tried selling them quickly.
It will be necessary to undertake the following review before an asset valuation can be fully considered:
- As has been said, there is a need to obtain current market valuations for the land and buildings.
- Also, obtain valuations for the plant and equipment and don’t forget any tooling, if it has a marketable value and is in current use.
- Exclude any intangible assets from the valuation at this stage.
- Review the stock of raw materials, work in progress and finished goods figures for any obsolete and slow moving lines that need to be either excluded or written down.
- Review sales ledger accounts for any bad debts or potential bad debts. Equally, consider any overprovisions for bad debts.
- The worth of any intangible assets can then be the subject of negotiation between the seller and the buyer.
Earnings Multiple Valuations using an established Price/Earnings Ratio
Multiples of earnings are most commonly used as a means of valuing a business. Generally, small business sales do not use asset based valuation methods to establish a selling price. The multiple earnings method is suitable for those businesses with an established financial history. The Price/Earnings or P/E Ratio as it is commonly referred to is a valuation ratio of a company’s current market share price compared to its earnings per share. But in very basic terms this represents the value of the business divided by its post-tax profits. A well regarded financial newspaper quotes the trading day’s closing P/E Ratios for various business sectors, but these relate solely to publicly quoted companies. If these ratios are used for valuing a small company, they should be reduced significantly as the barriers to acquiring a small company are substantially higher than if you were buying quoted shares on a recognised stock exchange such as London and the Alternative Investment Market. As a rule of thumb, typically the P/E Ratio of a small unquoted company is up to 50% lower than that of a comparable quoted company in the same industrial sector. However, quite often some business advisers just quote valuations for smaller companies that are in the region of 1 to 3 times the annual post-tax profits which may disregard the overall P/E Ratio quoted for the particular industrial sector that the company falls under. This is really not sound practice as it could undervalue those companies in particularly the High Tech or IT industries and also those companies with large non-valued intangible assets. But remember that P/E ratios are weighted by commercial conditions. A higher forecast profit growth will lead to a higher P/E ratio. Those businesses with a sound customer base and regular repeat revenues are usually considered sounder investments and as such will be given a higher P/E ratio. Always adjust quoted post-tax profit figures to give a more realistic and sustainable picture. I will refer to this at the end of my presentation.
Discounted cash flow – or sometimes referred to as earnings capacity
This method is the most technical way of valuing a business but it depends considerably upon assumptions about long term business conditions. This technique of valuation is used for those cash generating businesses that are stable and middle aged. The method uses an estimate of the business’s cash flow over a certain period of time, usually 5 to 10 years but can be up to 15 years. The terminal or residual value of the business also has to be calculated after this period of time has expired. The value of the predicted cash flow, plus terminal value is then discounted to provide a net present value figure or current business valuation. It may be hard to establish the terminal value as it relies so heavily on estimated cash flows. Understanding the terminal or residual value can be difficult to comprehend. The discounted net cash flow or earnings capacity approach determines the value of the business at the net present value of future cash flows. Having estimated the business’s free cash flow over the forecast period, you will need to come up with a reasonable idea of the value of the business’s cash flows after that period has ended, when the company has settled from middle age into maturity. The trouble is that it becomes more difficult to forecast cash flows over time. If you do not include the value of long term future cash flows, it would have to be assumed that the business had ceased trading at the end of the five to ten year projection time. So to make things a little easier a terminal or residual value approach is used that involves making some assumptions about long term cash flow growth. It is hard enough to forecast cash flows for five or ten years let alone after this. The complex formula for calculating the terminal or residual value simplifies the practical problem of projecting cash flows far into the future. But keep in mind that this formula rests on the big assumption that the cash flow of the last projected year will stabilise and continue at the same rate for ever. This will in fact be an average of the growth rates.
If a business can inspire a high level confidence in its long term prospects then this method underlines the business’ solid credentials. This valuation method could be used where a business may have a lot of potential but few assets and little financial history to speak of, such as an internet business.
The value today of each future years cash flow is calculated using a discount interest rate which takes account of the risk and the time value of money. £1 received today is worth more than £1 received in a year’s time etc. The discount rate is sometimes referred to as the cost of capital. It could be an average rate for a return on investment. Discounted cash flow can also use the rate of inflation.
The formula for calculating the terminal or residual value:
Terminal value equals the final projected cash flow multiplied by (1 minus the long term cash flow growth rate) all divided by the discount rate minus the long term cash flow growth rate.
Entry Cost
This method values a business by reference to the cost of starting up a similar business from scratch. An entry cost valuation reflects what this process would cost. To make an entry cost valuation would involve calculating the cost to the business of raising the necessary finance, purchasing fixed assets as well as working capital which covers stock in trade and cash funds or overdraft facilities, developing new products and services, recruiting and training the necessary employees and building up a customer base and reputation. Then it is necessary to make a comparative assessment, factor in any cost savings that could be made such as locating the business in a less expensive area and using more up to date technology and less staff etc. The entry cost valuation can then be based on cheaper alternatives which is generally more realistic.
Industry Sector Rule of Thumb
In some industry sectors, buying and selling businesses is common. In certain industries, where businesses change hands on a regular basis, this has led to the development of industry-wide rules of thumb which are dependent on factors other than profit, such as with sales revenues, the number of customers and maybe the number of outlets for a chain of stores. Examples of such industries include recruitment agencies, estate agencies, professional firms (accountants and solicitors etc.). Buyers will work out what a business is worth to them. As an example of this method, a competitor may pay a good value for a company just to obtain its valued customer base because it would merge the two businesses to generate larger profits from economies of scale.
Summing up
There is a caveat to all those valuation techniques that have been described to you. Despite their ongoing use, traditional valuation methods for businesses are so subjective that it is impossible to fully endorse them as totally foolproof. No two businesses are actually alike so if using other like businesses as a kind of barometer, great care must be taken. Furthermore, the financial figures being used in multiple earnings valuations are very often based on historical data and since they are out of date, great care must be taken in using these past figures to predict the future. Even when using asset based valuation techniques, they too can be subjective unless a potential buyer is able to fully validate the usefulness of all the assets to the business.
Notwithstanding the inaccuracies of these valuation methods, you should use a factor of at least two of the main techniques to value the business so that you obtain a view from every angle possible. You should work towards arriving at a range of values and then balance it all with what the value of the business is worth to you and also to a potential buyer. This should then ease the negotiations.
An asset valuation in general will give a minimum valuation whilst an earnings multiple valuation will give an upper price that will be more realistic if the business is making sustainable profits and is expected to do so for many years to come.
The number of valuations undertaken has fallen in general, but the desire to get a transaction completed still remains buoyant. However, as you will expect, in many cases the prices are different now to what businesses would have sold for in 2008.
How the profit figure that is used in valuations is arrived at
First of all, the unadjusted profit is taken after corporation tax but before any dividend payments have been included.
Then you look at working out the true profitability of the business.
Question any differences you find in the figures that are presented to you
A buyer needs to work out what the true profitability is. This can be done by following certain procedures.
Always compare any stated profits with the figures recorded in the audited accounts. If there are any differences, then question them.
Changes in accounting policy
The buyer and seller may have adopted different accounting techniques. Look to see if any cost areas require restating.
One off expense items
These will be non-recurring costs, not likely to appear on a regular basis such as gains or losses on asset sales.
Costs that can be reduced
Look for costs that could be reduced under new ownership such as employment costs, professional and consultancy fees, unnecessary leases or rentals, overlapping overhead or expenses that could be shared. Also, look out for any payments to the business owner or any shareholders. The new buyer could also be in a position to purchase some expense items more cheaply. Look to minimize any exposure to exchange rate fluctuations if these have arisen (and they do regularly) and any other external factors.
Additional costs that may arise under new ownership
When reviewing those forecast future profits, also consider any additional costs that might have to be incurred in arriving at them. These could include higher interest charges on borrowings, any retrenchment costs due to redundancies and increased depreciation charges following investment in new plant and machinery or even new technology. The arrival of a new management team could result in temporarily reduced productivity and higher costs until the settling in period has lapsed.
If you have not received all the financial information that you had expected to view, do not forget that a complete history of a business’s filings with the Registrar at Companies House is available for download and inspection at a very small price. A review of filings of a business can prove quite illuminating if you know what you are looking for so it is always a good idea to peruse these in any event.
Conclusion
At the current time, the market poses an interesting dilemma for those management teams that have traded successfully through the latest recession and who may now feel that they want to extract value from the progress that they have made. So many are now opting for a partial exit. This will be when a director sells shares in the business to a third party to take cash out of the business for themselves, whilst also maybe bringing in new investment which can take the business forward. Understanding the relevant valuation techniques will aid this partial exit route.
Confidence amongst dealmakers is presently quite fragile. Transactions are taking longer to complete than they used to and due diligence is much more in depth and challenging. Again, understanding and following those approaches to valuation that have been outlined can help smooth the deal.
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