Valuing a business

There are a number of approaches to valuing businesses and each of these valuation methodologies has application in different circumstances.

The following are the main valuation methodologies used by business valuers:

A.        EARNINGS BASED VALUATIONS

–           Discounted Cash Flows (“DCF”)

This method requires a formal business model and discounts free cash flows after excluding depreciation and allowing for expenditure on capital items.  As a prerequisite, it requires long term forecasts.  This approach is particularly suitable where the future performance of a business/company is likely to be significantly different from its past performance or where cash flows are expected to fluctuate substantially over time, due to major capital expenditure or for other reasons.

–           Capitalisation of Earnings

This method is a proxy for discounted cash flows.  It requires an assessment of the maintainable before or after tax earnings of the business/company, together with the determination of a rate of return (or earnings multiple) relative to that particular business for the purpose of capitalising the maintainable earnings amount.

The capitalisation of earnings approach is most readily applied when the historical earnings pattern of a business/company is sufficiently predictable of the earnings that can be expected in the future, or where other factors such as available forecasts or other indicators of likely future results are considered sufficiently reliable to allow reasonable estimates of future earnings to be made.

The Selection of the appropriate earnings multiple is usually the most judgmental element of a capitalisation of earnings based valuation.

The primary approach used by valuers is to determine the multiple that other buyers have been prepared to pay for similar businesses in the recent past.

In the absence of definitive or meaningful offers, it is necessary to infer the appropriate multiple from other evidence.

The capitalisation of earnings approach can be either on a tax paid basis (common with listed public companies) or on a pre tax EBIT (i.e. earnings before interest and tax) or EBITDA (earnings before interest, tax, depreciation & amortisation -where depreciation/ amortisations are a significant factor) basis which are more common with unlisted SME (small medium enterprise) businesses.

Each valuation will need to take into account a unique combination of factors, including (but not limited to):

  • Economic factors (e.g. economic growth, inflation, interest rates) affecting the markets       in which the business operates;
  • Strategic attractions of the business — its particular strengths and weaknesses, market position of the business, strength of competition and barriers to entry;
  • Transferability of goodwill (personal or business)
  • Rationalisation or synergy benefits available to the acquirer;
  • The structural and regulatory framework;
  • Investment and share market conditions at the time;
  • The number of competing buyers for a business
  • Future growth opportunities for the business
  • The relative proportions of tangible and intangible assets in an overall valuation

A pattern may emerge from transactions involving similar businesses with sales typically taking place at prices corresponding to earnings multiples within a particular range.

This range will generally reflect the growth prospects and risks of those businesses.

Mature, low growth businesses will, in the absence of other factors, attract lower multiples than those businesses with potential for significant growth in earnings.

An alternative approach is to review the multiples at which shares in listed companies in the same industry sector trade on the share market. However, this is nearly always not appropriate for SME’s (small to medium sized enterprises) in New Zealand as their size and other factors make such comparisons inappropriate.

–           Capitalisation of Dividends

This method requires an assessment of the maintainable dividends, together with the determination of a dividend yield appropriate to the business for the purpose of capitalising the maintainable dividend.  This approach is normally applied when valuing small or minority shareholdings.

B.           ASSET BASED VALUATIONS

–              Notional realisation of assets

This method requires an assessment of the realisable value of the company’s assets and liabilities, together with the expenses and losses (including taxation) that would be incurred if a break up or liquidation of the company were a possibility.  An assessment of the profit required by a purchaser is also needed to be allowed for in notional realisation of assets based valuations.

C.            INDUSTRY RULES OF THUMB

Industry rules of thumb are sometimes used in particular industries.  These rules of thumb may offer a secondary, market based approach to test values determined according to a capitalised earnings or discounted cash flow method or, in certain instances, they may provide a primary valuation method.  As such, industry rules of thumb must be considered where appropriate.

D.             MARKET STATISTICS

Where it is possible to get accurate sale price information from actual business sales of similar businesses, price comparisons should be made between a subject business and actual market sales information, provided there is a sufficient likeness between the two businesses being compared and where it is possible to accurately make allowances for the differences.

In New Zealand at the present time, there are limited sources available for obtaining actual business sales price data.

The only readily accessible database which records a large number of actual sales of businesses sold by a number of New Zealand business brokers is operated by BIZSTATS Ltd.

Business valuers usually calculate business valuations using at least two valuation methods, thereby enabling comparisons/cross checks to be made.

A fundamental valuation principle is that the value of any asset (including a business) is equal to its future cash flows discounted to net present value at a rate which reflects the risk inherent in the asset (business).

The valuation of businesses is a complex process.

Business buyers would be wise to seek assistance from people who are highly experienced in both valuing businesses and who also have had a lengthy involvement in actually buying and selling businesses in the market place if they wish to avoid paying too much for a business.

 

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