Business Valuations

There is no topic about which greater differences of informed opinion may exist than the value of a business or shares in a private company.

The value of a business is naturally influenced by the willingness of a vendor to sell and a purchaser to buy. It is usually assumed that fair value is a price at which a willing but not anxious purchaser might acquire the business from a willing but not anxious vendor.

It is always worthwhile exploring the factors that motivate the buyer and the seller.

Factors which influence a buyer include:

  • Employment — It is typical for redundant employees to seek to ‘buy’ a job
  • Security — Those who have experienced redundancy or vulnerability in employment often seek to become self employed
  • Challenge — It is common for people to reach a time in their life where they want a new challenge
  • Growth — Many people identify the opportunity to grow a business and achieve a significant return on investment
  • Lifestyle — The buyer might be attracted to flexible working hours
  • Perception — The buyer may be attracted by the status that self employment may create
  • Master of own destiny — The opportunity to be the decision maker has wide appeal
  • Specialist knowledge or passion in an industry — The buyer may have a particular skill in that industry or be very passionate about it

Factors that motivate a seller include:

  • Financial or liquidity problems
  • The business has failed to live up to expectations
  • A genuine desire to retire
  • Health problems
  • Succession to the next generation
  • Adverse market conditions
  • Impending competition
  • Marriage/relationship breakdown
  • The desire to pursue another opportunity

In assessing business or share valuations, the following usual methods are considered:

  • Capitalisation of future maintainable earnings
  • Capitalisation of future dividends
  • Discounted cash flow
  • Net Assets value
  • Liquidation value
  • Tangible assets plus goodwill based on super profits

The following table summarises the above methods and when they are most appropriate for use.

 

Method When Appropriate
Capitalisation of Future Maintainable Earnings
• Based on a future maintainable earnings stream to which a capitalisation rate is applied • Suitable when valuing large or controlling interests in a company
• Results of the business for the past five years should be obtained • Applied when the historical earnings pattern is sufficiently stable and predictable of the earnings that can be expected in future, or where forecasts are reliable enough to allow reasonable estimates of future earnings to be made
• Results should be adjusted for abnormal and extraordinary items which distort earnings
• Forecasts for the next two years should be obtained • If a Company has a history of losses, declining profits or liquidity problems, this method should not be used
• The capitalisation rate will be determined by risk
Capitalisation of Future Dividends • Normally applied when valuing small or minority shareholdings
• This method requires an assessment of maintainable dividends and a dividend yield appropriate for that business • Shareholder has no real say in the company and therefore no control over dividend policy
• This method is not appropriate if the company doesn’t have a history of paying dividends.
Discounted Cash Flow
• This method uses realistic forecasts of future cash flows, usually over a period of at least ten years • This method is suitable where the future performance is likely to be significantly different from past performance, or where cash flows are expected to fluctuate substantially over time
• This method requires a formal business model and discounts free cash flows after excluding depreciation and accounting for expenditure on capital items
• Items influencing the discount rate will include current interest rates and any general or particular future uncertainty
Net Assets Value
• This method requires all tangible assets to be valued and liabilities deducted to arrive at a net tangible assets value • This method is appropriate where a sole trader or professional practitioner is selling net assets plus goodwill
Liquidation Value
• Net assets are valued and adjusted for liquidation costs, losses and profits on realisation of stock, debtors and other assets, and tax on undistributed profits • Appropriate where liquidation is contemplated or possible because of size of shareholding (minimum of 75%)
Tangible Assets Plus Goodwill Based on Super Profits
• This method assesses the net value of assets to be sold. Goodwill is added to arrive at the total sale price • This method is appropriate where assets are generally readily realisable
• Typically used for sole traders
• This method values an earnings stream plus net tangible assets

Valuing Goodwill

The valuation of goodwill is generally focused on past, present and future factors.

Goodwill is only present when there is an excess of earnings over and above what a reasonable return would be expected on the net tangible assets employed.

Factors affecting a goodwill valuation include:

  • Location
  • Owner’s skills
  • Employees’ skills
  • Public image and branding
  • Dependability
  • Quality
  • Administration and systems
  • Products and services
  • Profit maintenance
  • Certainty of growth

A super profits approach is often used when valuing goodwill.

An established method for calculating goodwill on this basis is as follows:—

  1. Determine the net value of the business assets (tangibles).
  2. Multiply this by a rate of return you could expect to earn by investing elsewhere.
  3. Add a reasonable salary for the owner(s).
  4. This gives us a minimum acceptable return. If the business is not achieving this level of profit, any goodwill value is questionable.
  5. Calculate the average profit for the last few years, before tax and remuneration of the owner(s).
  6. Subtract the minimum acceptable return from the average profit calculated in step 5.
  7. The resulting amount is the ‘super profit’.
  8. Deduct taxation.
  9. Apply a profit multiplier, appropriate for the situation. The more established the business, the higher the multiplier. For example, a well established business might attract a multiplier of five, whereas a new business might attract a multiplier of only one.