You need to know the rules in order to break them successfully

Business Valuation

How much is my business worth?  Every Finance Director should know the answer to this question.  Otherwise how can you advise the Board of Directors should a hostile offer come in?  And it’s not just a question for quoted companies.  How can you advise the owner-manager approaching retirement, the chief executive considering a merger, or the start-up negotiating with investors?  How should you persuade the bank of your credit-worthiness when discussing the terms of a loan?  And if you are in a subsidiary of a large organisation, how should you advise head office if they are considered a sale?

It’s surprising how few Finance Directors can answer the question convincingly.  They appear to believe it should be left to investment bankers or, if you can’t afford their fees, the corporate finance department of your local accounting firm.  Perhaps they see it as beyond their domain and something only markets to decide.  Many regard such information as needed only in rare circumstances.  This is a bad oversight.  It’s reasonable to ask of any corporate strategy ‘How much will this increase the value of the business?’  While not exactly routine, and certainly open to challenge, nevertheless every Board of Directors should be familiar with their Finance Director’s own internal assessment of how much their business is worth.  If you are a non-Executive on a Board and don’t know, ask.

Pressed for a quick answer about how to value a business, without knowing anything at all about the company’s finances, I’d say ‘Anywhere between 2 x after-tax profits and 1 x turnover’.  Quite a range, isn’t it?  The purpose of this tutorial is to give you tools to narrow the range down.

There’s no ‘right’ answer

There can be no ‘correct’ answer in a business valuation.  It’s impossible.  Why?  Because valuation is based on an assessment of the future.  The future is unknown.  With precisely the same historic data, two people can, in good faith, arrive at radically different valuations if they differ in their assessment of the future.  This sets up plenty of room for negotiation and why you’ll hear people conclude a business is worth only a certain value ‘to me’.

This natural variability in valuation means we can never be precise and, consequently, we shouldn’t become over-elaborate in our valuation techniques.  Lack of precision however is not the same as lack of accuracy.  We should be aiming for a valuation that is accurate to within, say, + or – 15%.  If that seems quite a wide range consider that the stock-market routinely moves in a bandwidth of + or – 10%.  Achieving accuracy greater than that of publicly traded markets is unrealistic.  Remember also that valuations of even moderately complex businesses layer assumption upon assumption.  It takes only one or two errors before your valuation is way off beam.  In these circumstances achieving accuracy tolerances of ‘only’ + or – 15% is a challenge.

Valuation Techniques

The valuation techniques described below are considered in the context of valuing a privately-owned, mid-market business (turnover £25m-£500m), after due diligence, and where ownership conveys complete control of the company.  This contrasts with shares in a publicly-traded stock where purchase of a single share does not affect control of the Board and, although the market for the stock is very liquid, there is limited access to company information.  It also contrasts with a small business where the owner is intimately involved with running the business.

In reverse order of usefulness, these are the most common valuation techniques:

Assets

This technique asks the fundamental question ‘What am I buying here?’  It’s a good way of anchoring your valuation and making an early assessment of risk.  However, the question is only really relevant if you have reason to doubt the viability of the business and want to know what you’ll be left with if it all goes south.  For that reason, you’re only interested in realisable assets: cash, near-cash or property.  This technique is a good excuse for familiarising yourself with the company’s balance sheet.  There may be things there, such as cash or loans, that you might want to note for use with other valuation techniques.

Stay well clear of any metric of the book value of assets.  The data source is too unreliable.  Make your own assessment of the likely realisable value.

Dividends

If the company pays dividends, it is a straightforward mathematical to arrive at the present value of this future income stream.  In a zero-growth scenario, divide the latest dividend by the cost of capital: dividend / cost of capital (%).  In a more normal scenario where you expect the dividend to grow over time, the calculation is adjusted to be dividend/(cost of capital (%) – growth rate (%)).

Leaving aside the obvious problem that dividends paid by mid-market firms can be erratic, there’s a few other problems with this technique.

The first is that it’s not obvious why the technique is appropriate in the uncertain world of business.  It seems more appropriate to the valuation of fixed income streams such as bonds or commercial property.  Its usefulness as a valuation technique is therefore limited to businesses such as utilities or infrastructure companies with reliable, steady income streams.

The second problem is knowing your cost of capital.  This isn’t as difficult as you might think and for more information see my tutorial Discount Factor in Discounted Cash Flow.  However it does require an assessment of the riskiness of the business to be made.  This is disputed territory.

The Capital Asset Pricing Model (CAPM) is a long-established valuation technique.  Its main insight is that the cost of capital / expected return on risky assets is higher than that of less risky assets.  It goes further by offering a very precise method of calculating this difference, it calls ‘beta’.  It calculated beta by comparing an individual stock’s variability with the overall variability of the whole index, and taking the result as a proxy for the stock’s risk compared with the whole market.  You can see at once why this might work quite well.  And it must be very attractive to academic because of the objectivity and ease of calculation.  The trouble is beta turns out in practice not to be a very good proxy for risk and you are better off making your own judgement.  For more information see my tutorial Risk and Return.

The CAPM valuation technique for working out cost of capital is as follows:

 Expected return = risk-free return + β (market risk – risk-free return)

In this model, if base rates rise, your company valuation falls.  The accountant in me thinks this is unfair.  Changes to base rates shouldn’t affect the valuation of your business.  Any loans the company has will no doubt be at a fixed rate.  Profits are therefore unaffected.  However, as we mentioned before, if your potential buyers are influenced by an increase in base rates then your business is worth less to them.

Earnings

By far the most common valuation technique is to use a multiple of earnings.  It is, however, difficult to offer a theoretical underpinning for this technique other than to say it’s the ‘going rate’ for comparable assets.  Thus, while your analysis might suggest that gold is worth $900 for an ounce, if you want to buy it today you must pay $1,250 because that’s the market price, whether you think it’s fair or not.  Your valuation in this instance is more like a forecast.  Although much used in the real world we should nevertheless never forget that it is just a glorified benchmarking technique.  It’s useful but has limitations in terms of what it can say about an individual business.

The great advantage of the earnings technique is firstly that it focuses on the true source of wealth which is trading profit.  Assets and dividends are not primary sources of wealth.  Secondly, the technique is very easy to calculate.  Thirdly, there is a huge benchmarking database publically available in the shape of the stock market.

As the technique involves multiplying earning by a valuation multiple there are only two aspects of the calculation to discuss:

Earnings

There are some methodological decisions to be made before deciding on what earnings your valuation should be based.  Although Profit after Tax can be picked up easily from the accounts it is probably more reliable to use Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA) to arrive at a macro picture of earnings potential and then make separate adjustments for gearing, capital expenditure and tax.  For a full explanation of EBITDA see my tutorial EBITwhat?

Selecting your favoured metric of earnings is not trivial but it’s easy compared with settling on what figure to actually use.  The current year?  An average of the last three years?  Next year’s forecast?  Or a composite of the lot?  There’s a case for any one of the above.  At this point we discover a weakness in the earnings model.  It is strongest when earnings are predictable and weakest when the future is particularly uncertain.  Consequently it is less helpful for fast-growing businesses or businesses in declining markets.  This weakness can be compensated by adjusting the earnings multiple up or down but that’s not an entirely satisfactory.

Earnings Multiple

Deciding what earnings multiple to use is where most of the debate will centre.  The stock market is a good starting point.  The aim is to find a single stock, or a sector index, which most closely resembles the market and circumstances of your company.  I’d recommend using sector averages but be careful because they can vary enormously.  Pay attention also to gearing.  The closer you can get to matching the gearing ratio of your company to a comparable stock market benchmark, the closer you’ll come to having matched the market’s assessment of leverage risk.

Having found a comparable stock market benchmark, the next step is to adjust for the fact that the stock market is a highly liquid market of large companies run by professional managers.  This is a different order of value-risk proposition to a middle market company with shares held privately and rarely traded, run with smaller, less experienced management teams.

How much of a discount should you apply for illiquidity?  I’d recommend a range between 20% – 35% depending on how closely the firm resembles it’s more prestigious stock market cousins.  As the greatest volume of transactions are firms with turnover < £100m a discount of 33.3% is common.  What is the basis of this recommendation?  Partly, it was what I was taught during my professional training, partly it’s supported both by academic studies and by observed rules of thumb, but mostly it’s my own assessment of the differences between high, medium and low risk ventures compared to the stock market (which I consider relatively low risk).  For a more detailed explanation see my tutorial Risk and Return.

The table below offers different examples of illiquidity discount and resulting earnings multiple for a notional company that is comparable to the stock market average.

benchmarks

 

The second problem with the earnings method is it is quite difficult to reflect capital expenditure (capex).  Capital investment can make or break a business so it is very important to your valuation.  However by its nature it is infrequent and lumpy, while earnings are more smooth and more predicable.  By using a benchmark you’ll be adopting the market or sector average level of capital expenditure but this might be quite different from the capex planned in your company.  One way around the problem is simply to deduct foreseeable investment plans from your valuation but, again, it’s not entirely satisfactory.

The earnings multiple is easy to use but ultimately it should be a reality check on the pre-eminent valuation method: discounted cash flow.

Discounted Cash Flow

It’s difficult to see passed Discounted Cash Flow (DCF) as a valuation method, especially for privately owned businesses where you have good access to management but lack the sort of analytical ecosystem that surrounds publicly-traded companies.

There are several ways in which DCF and earnings multiples methods can converge.  They will both typically use EBITDA as a close proxy for cash flow.  And the selection of the discount rate for cost of capital is just the flip side of the earnings multiple as the chart below shows:

expected returns multiples

 

Under conditions of regular tax payments and predictable capital expenditure, the enterprise value estimated using long-term benchmarks of earnings multiples should align closely with the valuation estimated using discounted cash flow.  Indeed this is exactly what happened in my most recent valuation.  Even though the methods were completely different, they arrived at very similar results.

In terms of valuing the underlying cash generative power of a business, there’s not much to choose between the two techniques.  However, DCF has many additional advantages:

Growth

The DCF technique is superior a superior method for taking growth into account.  Firstly, you have almost infinite flexibility for adjusting cash flows to reflect changes in growth trends.  And secondly you can adjust the cost of capital used as the discount rate.  This allows for greater mathematical precision.  With the earnings multiple method, growth tends to be reflected in the earnings figure, which is a pretty blunt tool in comparison.

Having a more precise instrument for reflecting growth in your valuation is particularly helpful for fast-growing businesses.  However care needs to be taken when allowing for growth in the cost of capital.  An easy mistake to make is to assume above-trend growth carries on in perpetuity.  This is logically wrong and so I strongly recommend using a modest growth assumption in the cost of capital; something close to the long term average for the whole economy.  I use 1.15% because I believe productivity growth in a services dominated economy will be lower in the future than it’s been in the past.  In a breakthrough technology however it is perfectly possible to conceive of above-trend growth persisting for many years.  Remember though, even patent protection runs out after 20 years.

Cash Flow

The timing of capital expenditure is lumpy, meaning years can go past with light expenditure and then, for a couple of years, capital spending can go through the roof.  This ability to periodically drain the financial coffers is just the sort of thing DCF is good at handling.  Similarly, with other discretionary or semi-discretionary expenditures, such as marketing, R&D, debt financing, and dividend pay-outs.

Assumptions

With many more variables available, you can build a much more sophisticated model than is possible when simply multiplying two numbers together.  As noted earlier, sophistication need not mean complication.  Rather it allows you to bring in more real-world scenarios such as market share, competitor action, pricing.  In this way your cash flow valuation model becomes a sub-set of a wider model of your company’s strategic environment.

Modelling

The overwhelming advantage of DCF models is that they allow you to play around with the assumptions, model different scenarios, assign probabilities to certain outcomes, do ‘what-if’ scenarios and carry out break-even analysis.  No other valuation method can approach this level of usefulness.

What are the problems with the earnings technique?

The biggest pitfall, and it’s a significant one in my view, is a lazy tendency to do a few years cash flow forecasts and then shove in a hefty terminal value calculation.  Terminal values are required for the mathematical purity of the model but their effect is to assume the business goes on forever.  Moreover that it will go on forever in a steady, linear fashion.  Both these assumptions are not safe.  In fact you can be 100% certain they are wrong.

My preference for dealing with this problem is to take care in calibrating my time horizon to suit the circumstances of the transaction and then forecast out all years in that horizon leaving out a terminal value.  I consider this a more realistic, real-world basis of valuation.  How many years out do I go? Unless it’s a property transaction, I usually use 15 years and would never go beyond 20 years.  My imagination finds anything beyond 15 years difficult to cope with and, in principle, I think it’s impossible to see a generation ahead (taking a generation to be 21 years).  I find support in using this range by studies that claim the average lifespan of publicly-quoted companies these days has fallen to just 15 years.

A criticism of this method is that the values you use beyond 5 years become increasingly speculative and I wouldn’t disagree.  If you are not careful you can fall into the trap of assuming the business goes on in a linear, predicable way, in just the same way as I criticised in the calculation of the terminal value.  My counter argument is firstly to say that alternative methods have similar internal weaknesses but, more positively, I would suggest at least it gives you the opportunity to model non-linear scenarios, if you chose to take it.

Probably the second major criticism of the DCF method is that it is complicated, both in its calculation and in the use of multiple assumptions.  It is therefore prone to error either by a mistake in your spreadsheet or a rogue assumption giving an outlier result.  It also takes longer.

A final criticism is simply that much of the information needed to carry out a detailed calculation may simply not be readily available forcing a somewhat simplistic calculation that is, in effect, just a more complicated version of the earnings multiple.

Summary

At this point it’s probably wise to remind ourselves that we’re aiming for accuracy in a tolerance range of +/- 15%.  In fact you should use all the methods described above because no single technique will give you a ‘correct’ answer.  I’d recommend a discounted cash flow as a primary method with an earnings multiple to validate your DCF estimate and the dividend and assets valuations as back-stops.

Most of this tutorial has concentrated on privately-owned medium sized businesses, although the techniques apply equally well to large public companies.  But what about other types of business valuations?

Super-high Risk Investments

The valuation methods considered so far are not viable when it comes to super-high risk investments such as with start-ups, R&D-intensive firms, or investing in countries where the political, legal and economic environment is unstable.

In my view such activity defies valuation and should be treated not as an investment but expensed in the year.  In other words, don’t bother too much about estimating the return you can expect but ask yourself ‘how much can I afford to lose?’  This is an accountants-eye view of things where these investments are, in essence, worth zero until some threshold event is achieved.  As it happens there are financial instruments, options, contracts for difference, spread-bets, etc, that exactly reflect these situations, and there is a well established theoretical model for valuing these instruments.  It’s called the Black-Scholes options pricing model and it is well used in practice.  I mention it only as a way of thinking about an investment.  I’ve never seen it applied in practice.

Small Business Valuation

The businesses discussed so far have mostly been middle market: small compared to the international companies traded on the stock market but still quite large to you and me.  At the personal, individual scale, these ‘small’ businesses can still be quite large, with turnover as high as £25m.  At the other end of the scale, there are ‘micro-businesses’ where turnover is several order of magnitudes lower.

Regardless of size, the distinguishing characteristic of a small business is that it is dependent on the owner(s) to survive.  In the case of a micro-business such as a local retail outlet this might be because the owner is the only full-time employee or, in the case of a larger firm, the owner might be the driving force behind the business, with all the product know-how and customer relationships necessary for the firm to flourish. With a small business, if the owner dies, retires or sells up, the company risks going into terminal decline.  For this reason, all small businesses are high-risk investments.

One way of thinking about a small business is to treat its valuation as if you are ‘buying a salary.’  Your valuation mirrors the DCF calculation of making a payment today to receive a salary for a defined number of years.  Divide that DCF value by the amount of the salary and you’ve got an earnings multiple you can use to value the business.

The table below calculates such an earnings multiple based on the DCF of the average UK salary with statutory terms and conditions.

salary multiples

 

But how many years should you use for your earnings multiple?  As the average lifespan of a small business is 4.5 years, I’d recommend a maximum multiple of 4.6.  Such a multiple is probably appropriate only for companies with turnover approaching the upper limit of ‘small’ eg £20m-£25m.

As a guide for valuing small business, based on this ‘buying a salary’ DCF concept, I’d recommend applying these earnings multiples in the following illustrative scenarios:

small co multiples

 

It’s worth adding that the multiples above are not what I’d recommend you’d pay for the business.  These are your starting positions, you’d still need to calibrate these up or down depending on the particular circumstances of the individual business.  And these are not a substitute for doing a proper DCF calculations.

Conclusion

Ultimately a business is only worth what someone is willing to pay so all of these valuation techniques should be seen as preparation before getting to the negotiating table.  What happens after that depends on all sorts of human factors that no analytical technique can help you with.

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