Wednesday, 29 June 2016

Top 10 Finance and Business Valuation Terms for Newbies

There is a lot of jargon that is thrown around in the world of finance and business valuation.  This blog post attempts to lift the veil on some of the more commonly used finance & business valuation terms.  Although there are many, many more terms that could be included on this list, these listed below are but a sample....

1. EBITDA – it stands for Earnings Before Interest, Taxes, Depreciation and Amortization. To calculate the EBITDA of a business you would take the net income of the business and add back the interest expense, income taxes, depreciation & amortization. EBITDA is an “unlevered” measure of profit – it is a profit measure before interest expense is deducted. It is intended to be a proxy for pre-tax cash flow but it does have some deficiencies such as not accounting for capital expenditures, changes in net working capital or differing tax rates.

2. Enterprise Value – in business valuation, Enterprise Value (EV) refers to the total value of a company, its debt and its equity combined. The theory is that EV is a measure of a company's total worth without the 'noise' associated with its capital structure. Using a house as an analogy... if your home was appraised to be worth $1 million and you had a $600,000 mortgage on it then the 'EV' of your house would be $1 million and the equity value of the home would be $400,000 ($1 million less $600,000). To calculate the equity value of a business you would subtract business debt from its EV.

A commonly used business valuation ratio is the Enterprise Value / EBITDA ratio. Example - if a business is valued at $400,000 Enterprise Value and has an EBITDA of $100,000 then the EV/EBITDA ratio would be 4x.  This ratio could then be compared to industry peers.

3. Cost of Capital – is the cost of capital (debt & equity) that is invested in a business. Normally, a business valuator would calculate the weighted average cost of capital (the 'WACC') which is the cost of debt and cost of equity of a business. This WACC would reflect the total overall cost of capital for the entire enterprise (EV). If you only wanted to know the cost of debt, that is usually expressed as an interest rate. Calculating the cost of equity is a bit more involved (beyond the scope of this post), but equity holders generally require a higher return on their investment compared to debt holders so the cost of equity is usually higher than the cost of debt.

4. Working Capital – it is a business’s current assets less its current liabilities. Current assets are short term assets in a business which are expected to be converted to cash withing 1 year. Current assets include things like accounts receivable, inventory and prepaid expenses. Current liabilities are due within 1 year and include things like accounts payable. Working capital is a measure of a business's liquidity and overall health.

5. Current Ratio
– it is calculated as a business's current assets divided by its current liabilities. It is a measure of liquidity and tests a business's ability to meet its short term obligations. Example – suppose a business had current assets of $500,000 and current liabilities of $250,000 this implies a current ratio of 2x. A 2x current ratio means that there are $2 of current assets for every $1 of current liabilities.The current ratio should be analyzed by looking at trends (is it getting better or worse?) and comparisons to other companies in the industry.

6. Gross profit margin – the gross profit of a business is its sales less its cost of goods sold (or cost of sales). At a high level, it is intended to represent the profit before overhead expenses that a business generated. The gross profit margin is simply the gross profit of a business divided by its revenue, expressed as a percentage. So, if a business made $100,000 in revenue and off of that revenue earned $40,000 in gross profit (before overhead) then its gross profit margin would be 40% ($40k / $100k).

It is important to remember that gross margins can change. A business may get more (or less) efficient the bigger it gets.  When analyzing gross margins it is prudent to measure it over many different periods for comparisons purposes (months, quarters, years) to get a sense of what is happening and discovering trends. Also, it would be good to compare it to industry peers if that information is available.

7. Redundant asset – is an asset that is owned by a company but is not required to generate the profit of a business. Example – suppose you owned a private Ontario corporation. Suppose that corporation owned a home-based daycare business valued at $50,000. Suppose that same Ontario corporation also owned 2 acres of vacant land in northern Ontario appraised at $100,000. The redundant asset is clearly the land - you don't need the land to operate the home-based daycare. However.... don't be so quick to assume that the total value of the company was $150,000 ($50k for the daycare business + $100k for the land). The land may have embedded taxes. If it was purchased for less than $100k then there would be capital gains taxes to pay. A prospective buyer would not want to pay the full price since at some point they will be hit with a tax bill for the increase in land value. This is only a simple example but a chartered business valuator can assist with these types of scenarios.

8.  Goodwill - by goodwill I mean economic goodwill.  Economic goodwill refers to the intangible value of a business that is over and above its tangible assets and other identifiable intangible assets (such as patents, licenses, trademarks, etc.).

Simple example....  assume you determined that a going concern business was valued at $1 million in enterprise value.  Assume this business has $800,000 in tangible assets (such as net working capital, equipment, machinery).  The economic goodwill would therefore be the value over and above the $800,000 -- in this case the goodwill is $200,000.

9.  Minority discount - refers to the percentage discount applied to the pro rata value of a minority shareholding.

Simple example... pretend that the shares of a small, privately held business were valued at $500,000.  If there was only one shareholder of the company then his shareholding would be worth the full $500,000 (this is referred to as the en bloc or 100% value).  Now imagine that instead of one shareholder there were two shareholders.  Would each shareholders' position now be worth $250k each ??  ($500k /2).  Maybe... but maybe not.  Selling 50% of a privately held company is much more difficult and the shares would be much less liquid on the open market.  And if the 2 shareholders can't get along then there could be deadlock and chaos in the company.  So perhaps it would be appropriate to discount the pro rata amounts of $250,000 by some percentage to account for the disadvantage there is to being a minority shareholder.  This percentage discount to the pro rata amount is referred to as the minority discount.

10.  Book value
-  a company's book value refers to its accounting balance sheet value. The accounting book value of a company is simply its balance sheet assets less its balance sheet liabilities. It is a term that is often cited but, to be clear, this is usually NOT an appropriate way to value a business.

On a company's balance sheet, the asset values are typically listed at their historic cost amounts and there is usually a level of depreciation charged against them. To be clear though, this approach does not reflect the actual market value of the company's assets.  Accounting book value also does not include the economic goodwill of a business.  Economic goodwill is not reflected on a company's balance sheet.  If you were looking to sell or value a company you would most likely not sell or value it based on its accounting book value.

Please contact us for any business valuation issues.

Keystone Business Valuations

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