Valuing a Business

Most business owners want to know the value of their business at some point, including when they want to:

• sell the business entirely, for example when they’re ready to retire;

• realise some cash by selling some of their shares; or

• raise capital from investors by issuing new shares to fund growth.

Business owners therefore need to understand how businesses are valued to know what to do to maximise their business’ valuation well in advance of a valuation for one of the above being required.

There are various methods of valuing a business, the most common of which are:

• Asset based

• Market based; and

• Discounted Cash Flow

A.   Asset-Based Approach

The asset-based approach calculates value based on the net cash that would be received if all the assets were sold and the liabilities paid off. This is particularly useful for businesses with significant physical or financial assets that have a realisable market value, like property, or shares in other companies.

B.   Market-Based Approach

The market-based approach compares the business to companies that have sold recently that are comparable in terms of size, industry and market position. It analyses the prices those companies sold for as a multiple of their earnings and selects an appropriate multiple from this to apply to the earnings of the business being valued based on the relative quality of that business’ earnings, compared to the earnings of the companies that were sold.

Earnings quality is assessed by forming a view of a business’ ability to maintain and grow its earnings in the future. There are a broad range of specific factors that affect earnings quality and in turn the selection of a high or low multiple in a valuation. Common examples are as follows:

• Customer concentration: High concentration of revenue in the hands of a small number of customers represents a high risk to future earnings in the event one of those customers were to cease being a customer. Businesses with high customer concentration therefore have lower earnings quality and are valued at a relatively lower multiple than businesses whose revenues are distributed across a broad customer base.

• Reliance on key management: Strong dependence on staff, like the CEO, or sales people who hold relationships with key customers represents a high risk to future earnings in the event they were to leave the business. Businesses with strong staff dependence are therefore valued at a lower valuation multiple than businesses that have a succession plan in place to replace those people.  

• Sustainable competitive advantage: Sustainable competitive advantage significantly increases the likelihood of earnings not only being maintained, but also continuing to be grown in the future. Businesses possessing sustainable competitive advantage are therefore valued at higher valuation multiples than those that don’t.   Examples of competitive strengths a business might possess that support sustainable competitive advantage include:
  

  • Valuable intellectual property, such as unique brands, patents, trademarks and proprietary technology;

  • exclusive agreements with suppliers, customers and governments;

  • customers having to incur significant switching costs to move to a competitor; and

  • unmatched cost efficiencies due to economies of scale.

• High margins: High earnings margins are typically indicative of businesses with products that have strong demand and limited competition that can therefore charge higher prices. In addition, they may also have cost-efficient operating models. Businesses with high margins therefore have high quality earnings that are valued at higher valuation multiples than lower margin ones. Companies selling successful new technologies are examples of businesses that generate high margins by being able to charge high prices, because they have relatively little competition. In addition, those selling subscriptions have a recurrent annual revenue stream being generated with minimal incremental cost. Technology companies are consequently valued at higher valuation multiples than businesses in other industries.

• Business lifecycle: Long-established businesses with a proven track record of delivering consistent earnings streams are usually valued at a higher multiple than earlier stage businesses that haven’t demonstrated an ability to do this. For this reason, it is preferable for an owner to sell a business after they have at least 3 years of proven performance behind them.

EBITDA (earnings before interest, tax, depreciation and amortisation) or EBIT (earnings before interest and tax) are the measures of earnings commonly used to apply a multiple to, to value a business. This is because a business’ value is underpinned by the cash it will generate in the future and EBITDA and EBIT represent a proxy for cash, depending on the type of business.

A manufacturing business with significant capital expenditure requirements for example should be valued using EBIT, as depreciation captures the annual plant and equipment cost. A professional services business on the other hand with no plant and equipment would be more appropriately valued using EBITDA.

The market-based approach is the most common method used to value businesses with stable and predictable cash flows, particularly where there are reliable multiples available from other comparable businesses that have been sold.

C.   Discounted Cash Flow

The discounted cash flow method projects a business’ future cash flows and discounts them back to their present value using a discount rate. It is theoretically the most accurate approach to valuing a business, because it captures forecast cashflow over a long-term time horizon and the discount rate factors in the time value of money and risks attached to the forecast. However, the valuation is reliant on the quality of the forecast, which is usually based on subjective assumptions. Therefore, the discounted cash flow method is typically used when the market-based approach is not appropriate, for example for valuing:

• high growth businesses, especially those that are currently loss making with a pathway to profitability;

• businesses with finite earning streams, such as those with material customer or supplier contracts that will expire at the end of their terms; and

• companies requiring substantial upfront capital expenditure to generate future earnings growth, such as in the infrastructure and oil and gas industries.

Valuing a business is therefore both an art and a science. Whether you are selling, buying or investing, an accurate business valuation is arguably the most important component in the decision-making process. It can be complex, may necessitate subjective judgement and therefore may require the expertise of an accountant or professional business advisor such as Total Advisory Partners.