HOW TO VALUE A BUSINESS – DO YOU AGREE?

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There are a number of methods used to value businesses. How best to value a business will depend on a number of factors.

Although financial modeling is essential, it is first critical to consider the market place and transaction strategy from both the perspective of the buyer and seller.

The best valuation methodology and price positioning will depend on the marketplace, company size, profitability and nature of the business.

Below are the seven most common methods used by CFOs and Corporate Finance teams involved in merger and acquisition (M&A) activities.


1) Discounted Cash Flow (DCF) Method

The DCF method is typically the most robust approach, although generally not applicable to small and medium sized businesses (i.e. businesses with revenue below 
£25 million).

The DCF method attempts to put a value, in today's terms, on future cash flows in an enterprise.  The future net cash flows of the business are discounted back to present value.

Future cash flows consist of two elements:

  1. Net cash amounts generated each year
  2. Net cash expected from the ultimate sale of the business at a given point in time


In order for DCF to be a robust methodology:

  • Future cash flows need to be able to be predicted with reasonable accuracy, such as mining companies or large, stable companies.  It could also be applied where a small or medium company has long term contracts for the supply of goods and services or where the company has a history of regular cash flows.
  • Cost of capital and risk associated with the future cash flows can be easily quantified


Unfortunately, it is generally not suitable for valuing most other small to medium companies because of the difficulty of estimating cash flows some years into the future, the difficulty of estimating the sale price of the business in the future and the difficulty of assessing a suitable discount rate.


2) Internal rate of return (IRR)

IRR has been a popular method, particularly for private equity (PE) firms.

IRR is important to PE firms because they raise money from investors by offering them returns on their investments. If the yield on purchasing a business is too low it makes raising funds from investors difficult. Investors choose funds that have consistently delivered high rates of return.

IRR % = [Future Value / Present Value ]^1/N -1

N= Number of periods e.g. years.

IRR is often not a good basis for decisions and can be misleading.

  • For some businesses that have cash inflows followed by cash outflows, the NPV rises as the discount rate is increased. In this case, where the IRR is less than the cost of capital the price should be acceptable. 
  • If there is more than one change in the sign of the cash flows there may BE several IRRs or no IRR.
  • The IRR rule may not be used to accurately rank or compare different businesses if the cash flows vary in time or scale.



3) Return On Investment (R.O.I) Method

This is the most common method used to value businesses worth up to about 
£5 million. It reflects the percentage returns to an owner on his capital investment in the business.

Return on Investment (R.O.I)

=

Net Profit

x

100

 

 

Purchase Price

 

1

 

Net profit used in the calculation:

  • Profit reported in the Profit & Loss Statement.
  • Less: Operational costs not reflected in the expenses that would be incurred to sustain the business as a standalone entity, e.g. business management costs that may be incurred but not charged through the business
  • Add: Non-business expenses and one-time expenses, e.g. expenses related to legacy parts of the business that are in run-off or not being sold with the business.

 

The appropriate R.O.I. is usually linked to the industry, and the best benchmarks are the purchase prices relative to profits of recent deals.

Given the R.O.I. for a specific industry (and making adjustment for special features of a particular business), the valuation is arrived at by transposing the above formula.

 

Purchase Price

=

Net Profit

x

100

 

 

 

R.O.I.

 

1

 

Goodwill embedded in the price can be derived by subtracting the value of assets purchased from the total purchase price.


4) EBITDA Method

Most common method of valuing private businesses worth around 
£5 million and above.

Value of business = Profit x EBIT(DA) Multiple


Two typical options for earning that are used in the calculation:

  • EBIT – Earnings before interest and tax.
  • EBITDA - Earnings before interest, tax, depreciation and amortisation.


Relatively few add-backs are made to the book profit when valuing large businesses as the profit and loss accounts typically reflect running expenses (unlike many smaller businesses).  Interest is added back and depreciation in some industries such as technology where significant investment in hardware and development is commonly capitalized and depreciated.

The EBIT(DA) multiple to be applied to value a business can vary from around two up to around ten, and sometimes higher, depending upon a number of factors, including:

  • Industry and market opportunities
  • Historical and potential future growth
  • Scale of the business
  • Quality of the management team
  • Industry barriers to entry



5) Price to Earnings (P/E) Method

The P/E method is used to value public companies, and can also be used to value private companies.

The P/E method is essentially the same as the EBIT method except that the after-tax profit is used in the calculation and a different ratio is used to compensate for this.

The P/E ratio can be calculated based on published public company information.  
The method requires locating a few public companies similar to the one being valued to obtain an average P/E ratio that can be used as a benchmark for price negotiations.

If the business targeted is privately owned, the price is usually discounted anywhere from 50% – 80% per cent to reflect the generally smaller size of the business and the lack of share liquidity compared to public companies.
 


6) Gross Income Multiple Method
 

 
Traditionally a very popular method that simply values a business as multiple of its gross income, each industry having its own multiple

No longer a popular method because costs incurred to earn the same income can vary significantly, businesses within the same industry may have very different margins due to geographical location, long-term contract pricing with business partners, etc.

Some businesses with simple and mature business models, particularly those with mainly headcount related cost structures such as accounting practices and property brokerage businesses may still look to apply this method.



7) Asset Based Valuation

This method is used when other valuation methods give a value that is less than the net tangible assets of a business. Goodwill and intangible assets are not included in the calculation.

  • Businesses that are not considered a going-concern
  • Unprofitable businesses in weak or declining markets
  • Capital investments expected to translate to profitable growth


The value of fixed and current assets including property, infrastructure investment and other equipment and stock is valued at market value. 

The asset valuation is based on the concept that a business owner is highly unlikely to sell his business for less than he can receive through sale of the business assets.

Stock is initially valued at invoice cost but may be discounted depending upon the amount of slow-moving or obsolete stock.

In the case of other assets such as technology infrastructure, the value is likely to be considerably less than book value due to the pace of change in the industry and need to regularly upgrade and replace equipment.

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