How to Value your business (or, how anyone buying it is likely to value it)
At some stage any owner of a successful business is likely to receive an offer or at least a discussion about selling their business. For many entrepreneurs such an approach is flattering but not something they wish to consider at that time. However for those not adamantly opposed to considering selling the business it is useful to have a clear idea of how any would be acquirer is likely to value the business. The business owner can then consider if any offer received is a fair one.
Whilst the subject of business valuation is a dry one and covered in detail in voluminous corporate finance textbooks, the following guide and our 7 key rules of valuation give you the basis on which to approach the task
1. Cash is best, profit second best sales the least satisfactory (traditional) way of valuing a business
There are a multitude of valuation methodologies in popular use ranging from absolute methods such as Discounted Cash flow or Economic Value Added or relative approaches using valuation multiples such as Price to Free Cash Flow, Price to Earnings, Enterprise Value to EBITDA)
At the heart of most generally accepted valuation methodologies is the need to use clear (audited) financial metrics as the basis for valuation. What metric used depends on the company and its current state of development
Free Cash Flow. In a world where cash is not just king, it is King, Queen, Prince and any other member of the royal family, the most satisfactory way to value a business is on the basis of its cash flows. In the long run shareholder returns in the form of dividends have to be paid from cash flow not profits. Put another way profit is an opinion, cash is fact.
Free cash flow (excluding payments of dividends, interest and repayment/draw down of debt) is the basis for a discounted cash flow valuation that forecasts cash flows into the future and discounts back to present day values. It is also the basis of using a valuation multiple approach using the Price/Free Cash Flow multiple. Given the fact that many companies produce healthy profits but modest cash flows a valuation methodology that takes account of cash generation would give any acquirer most confidence on the value they could generate from your business. For that reason any acquirer is going to look at your businesses Free Cash flows first
However, there may be reasons why your businesses current cash flows are not representative of the future shape of the business (e.g. Cash flows are negative as a result of high capital expenditure or one off changes in working capital). In which case a profit based multiple will be the next most satisfactory way of valuing the business.
Profit: The measure of profit used could be Profits after Tax (the basis of the traditional Price/Earnings valuation multiple) or EBITDA or EBIT (Earnings before Interest Tax Depreciation and Amortisation or Earnings before Interest Tax) which allow the person valuing the business to fully take into account the capital structure of the business (does the business have a net cash or net debt position? What is the ratio of Net Cash/Debt to equity)
Sales: Finally there are circumstances when a sales based multiple will be used to value the business. The first is that the business has yet to reach the levels of profitability and cash generation that it is expected to (or that it profits/cash generation has dipped but is expected to recover). The other is that the business is being acquired by a much larger competitor, who will be able to impose a completely different margin structure on the business. Examples of this can be in the consumer goods sector where the likes of the global groups with a wide portfolio of brands make acquisitions and valuation is made on the basis of revenue multiple
There are certain industries or certain situations where an asset based approach to valuing the business might be appropriate, this is discussed in more detail as part of rule 6.
Having discussed valuation based on key financial metrics based on your business’ audited accounts there may be some businesses valued on the some metric not found on a financial statement such as price/subscriber, price per click or other exotic method. Since the tech bubble at the turn of the century such methods have been out of favour. Such methods could be used to value a company that is not yet producing meaningful cash flows or profits or even sales but has a game changing technological business model, and scale to fend off interlopers that gives confidence that sales, profit and cash will soon be forthcoming. However if that describes your business you will find there are no shortage of corporate finance advisers willing to give you advice anyway
2. Cash/Profit/Sales now (or soon), not in the afterlife
Having clarified what measures of performance is likely to decide the valuation metric used, this leaves the question what is the most relevant year to take into account. Here there will invariably be a conflict between an acquirer wanted to value on things that are known (the most recent set of accounts) and the business owner who invariably is 100% confident that profits will have doubled within three years, so want to use the year three forecast numbers. The point to stress is that you may be very very confident in your year three profit predictions, for them to be of any relevance to the would-be acquirer they need to have similar level of confidence in your forecast. Certainly if they are experienced in M&A they will have seen a lot of very optimistic profit forecasts for business that never materialised into actual profit growth. Therefore the likelihood is that any acquirer will take either your last year’s set of accounts or the forecast for the current year.
3. Know who is interested in your company, what will they do to it and what will cash/profits/sales be under them
Any potential owner of your business running the numbers will put together their own forecasts of what profits would be if they acquired it. This will include any efficiency they believe they can bring to the business, with these potentially coming from synergies if the acquirer owns other business and can therefore extract synergies such as buying efficiencies. It will be the post synergy profit forecasts that will form the basis of their valuation calculations.
Estimating what synergies a potential acquirer can achieve is a hugely speculative exercise. Furthermore even if they are forecast accurately, this leaves the little matter of how to work them into a valuation of your business. It should be understood that synergies are by no means assured and come with the downside risk of combined profit actually going backward as a result of adverse reaction from staff and/or customers to the acquisition and integration process. Therefore the overriding principle should be that given this risk the bulk of the valuation upside should go the acquirer.
It is probably useful to give a hypothetical illustration. The owner of Company A operating in retail industry has had an approach from a large retail group Retail Giant Plc. Detailed analysis of recent transactions in the industry has shown a consistent average transaction multiple of 10 times post-tax profits. The forecast Profit after Tax for the current year is £20million, but based on experience of similar transactions the owner of Company A believes that Retail Giant will be able to achieve buying synergies that will increase post-tax profits by 20%.
On that basis the pre synergy business is worth £200m (10 X £20m) and the post synergy business worth £240m (10 X £20m x (1+20%)). However if the owner of company A demands £240m for the business, the Directors of Retail Giant PLC are likely to conclude that it is not worth the risk since if they fail to meet to achieve 100% of the synergy targets the business is worth less than the price they paid for it.
What is more realistic is for the owner of Company A to include somewhere between one third to a half of the expected synergies in the profit and multiply it by the valuation multiple to suggest a realistic value for their business. This would suggest a valuation range of:
(10 x (£20m x (1+ (20% x 1/3)))
(10 x (£20m x (1+(20% x 1/2)))
OR £213.33m to £220m
4. Choose your index or comparison companies wisely (or take account of any differences with a valuation discount or premium)
A relative valuation approach applies a valuation multiple derived from comparison to similar business to a key financial metric for your business such as Free Cash Flow, Profits or Sales. It could potentially involve applying a discount or premium to the multiple take account of specific characteristics of the business being valued. The critical issue here is using relevant and appropriate points of comparison. This may be the rating of a particular company or group of companies, but what is critical is that the companies are as similar for comparison purposes as possible. Here similarity can mean a number of different things
I. Similar market niche: Do the businesses you are comparing your business to operate in the same or similar market place. This does not mean the same industry, a fast food restaurant and a Michelin starred restaurant operate in the same industry but work in different market niches that have very different drivers and growth rates.
II. Similar competitive resources and capabilities: By choosing businesses from the same market niche you will be comparing businesses facing similar if not the same opportunities and threats. But just as important it is useful to choose firm with similar competitive strength or weakness (if possible) and to account for any differences in a valuation discount or premium. Put another way a clear market leader with should (other things being equal) be on a different rating to a much less powerful rival without scale or significant brand equity. This is not simply a matter of scale; there are many small niche players who have built up the kind of brand loyalty amongst consumers their larger rivals could only dream of. What it is about is a sober analysis of the competitive advantages or disadvantages of a businesses and where possible choosing similar points of comparison, if not reflecting differences in a valuation premium/discount.
III. Similar growth profile: Very closely linked to, but not exclusively related to points I & II is the issue of the growth profile. Where possible it gives a relative valuation weight if you are comparing your business to other businesses (or the average of a group of other businesses) that have similar growth rates. Failing that any differences in growth rates should be reflected in a valuation multiple discount or premium.
Ultimately all businesses are different and in doing a relative valuation of the business using information you can only use the information you get. The key is to recognise such differences and take account of them in your valuation.
To use an example, your business operates in a market niche where there is one other firm operating on which you can get valuation information which is valued. That business is mature one with modest sales and profit growth of 3-4% over the past few years, whilst yours has produced low double digit sales growth and is expect to do so for the next few years it would be appropriate to apply a valuation premium to rating the more mature business is on, with something in the region of 15-20% seeming right.
5. Don’t forget the issue of takeover premium
If one uses valuation multiples these can either be from businesses that are quoted on the stock market (where the share price for any business allows one to calculate valuation multiples) or come from information about M&A transactions, specifically deal price information which also allows one to calculate valuation multiples . Where businesses are bought completely and ownership changed they sell for a premium compared to the value they were trading at before the takeover bid, with something in the region of 30-40% being typical. Assuming that you are interested in the latter option rather than some sort of theoretical value of what your company might trade at if it were traded on the stock market, you should use either takeover multiples or apply a takeover premium.
6. Understand when asset based valuation is appropriate.
There are situations where the normal rules of valuation of using a discounted cash flow valuation of relative valuation using financial metric that comes from the P&L . We have already mentioned valuation metrics such as price/subscriber or price/click that have been used to valuation tech and telecoms businesses. However even for businesses operating outside the rarefied world of tech and telecoms there are times when different valuation approaches are appropriate. The first is that there are a number of industries such as property or investment management where asset based valuation used based on metrics like Price/Net Asset Value or Price/Funds under Management might be used. Similarly for a distressed business that is unlikely to be sold a going concern price is likely to be determined by asset value, although in such a case the overwhelming likelihood is that the assets will be sold separately from the company and that after creditors have been paid there will be nothing left for the owners of the business
7. Any purchase price is determined by supply and demand , not a corporate finance textbook
Finally it should be understood that even if you fully appreciate points 1 to 6 and incorporate them into your valuation, the price your business can fetch is determined by who wants to buy it and their willingness to pay. That could mean you are lucky enough to be the subject of a bidding war between rival bidders where corporate vanity trumps sober valuation calculations. It could mean that your would-be bidders have been burnt by the experience of previous acquisition and integration programmes that failed, and attempt to build in a lot more slack into their valuation and synergy calculations. That said if you take on board points 1 to 6 you are on the right track for understanding how a would be acquirer might value your business.