Friday, 18 March 2016

How to Value a Business

This blog post will give a high level overview of the principles involved in valuing a privately owned business.

First thing to consider - is the business a going concern?

If the business is not expected to be able to carry out its financial obligations or remain viable, solvent and remain operating then generally the business would be valued on a liquidation basis.

In a liquidation basis, the assets would be valued at the amount they would be able to fetch if they were sold off, net of disposition costs, corporate debts, corporate taxes and personal taxes. In a liquidation approach, it is important to understand if it is to be a forced immediate liquidation or an orderly timely liquidation. In a forced liquidation the assets might not fetch as much money if they are to be sold off quickly, costs might be higher and generally the resulting valuation in a forced liquidation would be lower compared to an orderly liquidation.

However, if the business is a going concern, then there are three main approaches that could be used:  the asset approach, the income approach or the market approach.

The Asset based approach

If the business you are trying to value does not have commercial goodwill, or if it is generating a return that is below what should normally be realized for the assets invested in the business but it is not quite at liquidation yet, then an asset based approach would probably be the primary approach to value the business.

In an asset based approach, generally the assets and liabilities on the company's balance sheet are restated to market values. There is some more nuance to this approach that involves some technical items like lost tax shield, deferred income taxes and other items but at a high level the idea is to restate the balance sheet to current value, make some technical adjustments to a few specific items, then the restated equity (also known as the adjusted book value) would be the resulting value. In an asset based approach the key point is that there is no economic goodwill in the business that is being valued.  An asset based approach is also usually used when valuing a holding company.

Income based approach

If the business does have economic goodwill then you would likely want to look at valuing the business using an income based approach. In an income based approach, the business is valued using it's earnings or cashflow.
There are many different methodologies in the income based approach, such as:
  • capitalized excess earnings method
  • capitalized earnings method
  • capitalized cashflow method
  • discounted cashflow method
  • capitalized EBITDA
  • capitalized EBIT
The basic idea to all of these methodologies is the same – what is the present value of the future cashlfow of the business? In order to know this we must know what the estimated future earnings or cashflow are AND also what the cost of capital for the business is.

When we can make a reasonable estimate of the future earnings or cashflow of the business then we must calculate what the present value of the future cashflow is.The principle of present value is that receiving $1 one year from now is worth less to a person than having $1 at the present time. Therefore getting $1 in one year from now might really only be worth $0.90 (or something different) to you now, depending on the risk of achieving that $1 in the future and also the time value of money. Using this principle, the future annual earnings or cashflow of the business are discounted to the present value to determine the present value of the business.

Calculating the cost of capital (the rate at which to discount the stream of future cashflow) for a business can be a technical and subjective exercise. There a number of different ways to estimate the cost of capital for a business (beyond the scope of this blog post) but it essentially involves calculating the weighted average cost of a business's overall cost of equity and cost of debt.

So, as a simple example:

Assume a company is expected to earn $100,000 in net cashlfow and this annual cashflow is expected to grow at a rate of 2% per year. Assume that we have determined that the overall cost of capital for the business is 22%.  How would we calculate the value of the business?

You can determine the value of the business by capitalizing the cashflow, as follows:

Cashflow / (total cost of capital – expected growth rate) = Value

= $100,000 / (22% - 2%) = $500,000

The $500,000 would represent the total value of the business. If you wanted to determine the equity value of the business you would subtract any debt from the $500,000 and the net result would be the equity value of the business.

Now this is a very simple example but the principle is sound. Estimating the future cashflow is important to getting an accurate value. Calculating the cost of capital and estimating the future growth rate is critical too. Small variances here can have a big impact on the final value.

In the “real world” there are usually many more moving pieces involved, such as:
  • what if the business had insufficient working capital, how would this be addressed in your valuation?
  • what if you expect corporate tax rates to change next year?
  • what if the business has not invested in capital expenditures and needs an injection of equipment – how would this impact value?
  • what if the business owned a lot of valuable equipment that it no longer needs to generate its cashlfow – how would this be dealt with?
The key is to understand all of the moving pieces of a business and then properly deal with them to get a more accurate valuation.

Market based approach

The market based approach to valuation is really a subset of the income based approach. The general idea here is to look to the market for valuation multiples and then apply these multiples to the subject company to determine value of the subject business.

As a simple example...

Suppose you own a pencil factory. As an example, you could calculate your business's Earnings Before Interest and Taxes (EBITDA) and then see what multiple of EBITDA other pencil factories are valued at in the marketplace and then apply that market EBITDA multiple to your pencil business to determine value.

So, if your pencil business generated $100,000 per year in EBITDA and you determined that the “market” EBITDA multiple for similar pencil factory businesses is 4x then you could say your pencil business might be worth $400,000 ($100,000 x 4x).

It may seem straightforward but there are many caveats to this approach. The key here is to get accurate market multiples from similar companies and ensure that you are doing an apples to apples comparison, which is usually very difficult.

Where can I get market multiple data from?

There are generally two places to look for comparable market multiple data:
  • recent transactions (sales) of similar businesses – assuming you can get access to the information
  • public markets (i.e. the stock market)
Let's look at the each of these specifically:

Market multiple data from recent transactions of comparable companies

Privately held companies do not have to publicly report what they sold for so getting good data from a comparable private company sale is very, very difficult. If you were somehow able to get information on some private company sale transactions the challenge would be that there are many differences that still may exist that may make a good comparison with the subject company difficult. For instance, you don't know if the purchase price of the comparable company included synergies that wouldn't apply to the subject business. Also, if the comparable company transaction was not an all-cash deal then you must equalize the form of payment used in the transaction. For instance, if the comparable company transaction was financed with a large vendor take back note or an earn-out then this must be considered when making a comparison. Also, what if the comparable company transaction was not recent? What if the comparable company transaction was in a different geographic market? You also need to ensure that the “value” you're comparing is the right one – in other words, what if the value of the comparable company was equity value but you're comparing it to the subject company's enterprise value (equity + debt), this would be a big mismatch and would throw your valuation off.

Market multiple data from the public markets (the stock market)

If you are looking to value a private company you could possibly look to the stock market since publicly traded companies need to disclose their financial information every quarter and you would know what their shares prices are trading at to the second.

However, you must realize that there are some inherent difficulties in comparing the relative value of a privately held company to a publicly traded one. Public companies are usually much larger than private companies, more geographically diverse, have professional management, their shares are more liquid, their cost of capital is generally different and so on. Also, a public company's product or service offering might be materially different than the subject company, they could be more integrated with their suppliers, have more buying power, and so on.

The key to the above is that you must be very careful in applying market transaction multiples or public market multiples to a subject company for the purpose of a valuation. For the above reasons, the market approach is a good secondary approach in a valuation engagement. In other words, it can be a test of reasonableness for the primary approach.

Rules of thumb

A rule of thumb is not a generally accepted valuation "approach" but (too) many people rely on them so I will make a few comments on using a rule of thumb in a valuation.  A rule of thumb is generally a valuation formula that is “known” in a particular industry, such as that an accounting practice might be valued at 1.2x its revenue (not real, just for illustration purposes).
However, rules of thumb should not be relied on to value a business. There are many risks to doing so. For instance, a valuation rule of thumb can develop from an “urban myth” without being based on any real substance. Also, there is no clarity on if the rule of thumb is based on equity value or total enterprise value of a business. The rule of thumb may be outdated, technically incorrect, too broad to be relevant, not relevant to your particular market, and so on.

A proper valuation should be based on careful consideration of a business's opportunities, risks, cost of capital and overall view of it's operating environment. Not a 'rule of thumb' rumor.

Please contact a Chartered Business Valuator for assistance with a business valuation.

Keystone Business Valuations – serving the GTA & southern Ontario
Steve Skrlac, MBA, CFA, CBV

This post touched on some general valuation issues and approaches and is not meant to be professional advice.

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