A valuation is not just a set of formula that produce a dollar figure and we decide that is the price for the business.
A Valuation is an Experts' View
Before looking at the methodologies in valuing a business it is important to remember that:
For each valuation there are some basic concepts (I call them the Core "S" questions) that must be first defined:
- A valuation is a process where someone forms a view as to the range of values at which a financial asset is likely to be exchanged.
- The value range should be arrived at using an evidence-based process.
- The valuation process should be consistent with current methodology and industry standards.
- The valuation report should be transparent and reproducible.
It is only after considering each of these Core "S" questions that we can decide on the appropriate valuation method.
- What is the scope of the valuation?
- What is the solvency of the financial asset and how will this impact the valuation?
- What is the standard of value required?
- What is the scheme of valuation (the valuation methods to be used).
What are the Broad Methods of Valuation?
There are a number of approaches that are generally accepted for valuing businesses. Most of these valuation methods typically fall within the following categories:
The Income methods are based on the profits of the business. The Excess Earnings methods are similar to this but consider the earnings or income above expected industry levels.
- Market Based.
- Income Based.
- Asset Based.
- Cost Based.
In many cases various authorities (ATO, the courts and ASIC) consider the above hierarchy as a preference when selecting valuation methods. In other words, where information on a relevant market transaction is available, it considers the market based methods to be representative of market value.
This assumes sufficient information is available to arrive at a credible and reasonable valuation range.
In other circumstances, such as when raising finance for an early-stage startup, the preferred method of valuation is the "last money in", or the implied valuation based on the most recent investment that was made. This may be considered a particular example of a market based method, where the most recent transaction is the last investment made.
When selecting a method of valuation, a primary method is selected that is considered the most appropriate to arrive at a valuation range. Other method(s) are also selected to provide a crosscheck on the primary method.
It is important to select a primary method that is not only appropriate, but where reliable and recent information is available to complete the assessment.
So let's look at some of the particular valuation methodologies under each base.
Market Based Approach
This approach considers the amount at which a business can be sold i.e. the highest value that someone is prepared to pay in an open market on a willing buyer and willing seller basis.
This method is usually based on comparable transactions of similar assets that are bought and sold in recent market transactions. Where reliable information is available, this method may form the basis of the primary valuation method.
It compares the value of a past or proposed transaction where the business transacted has some similarity with the business being valued. Adjustments to the transaction are made to take into account key differences in circumstances or conditions of sale.
In most cases market methods will collate information on the earnings and the multiple associated with the transaction and apply this information to the business being valued. Adjustments to the multiple may be made to take into account differences in size, nature of the business, location and marketability.
In the case of startup businesses, or where the business is making losses the market transaction method may use revenue or some other metric to compare the business being valued to the business that was transacted.
In the privately held market, there is often a lack of detailed information publicly available on the purchase price, underlying terms and conditions of the transaction. In these circumstances assumptions are often made to arrive at a valuation range, and as such this method is often used as a cross check to the primary method.
Income Based Approach
The income based methods capitalise a proxy for cash flow using a measure of capitalisation.
There are two common methods used as income based methods:
- Earnings Multiple
- Discounted Cash Flow
This conventionally accepted method capitalises the historic earnings or future maintainable earnings (‘FME’) of an asset / business by an appropriate capitalisation or investment rate.
The rate is based on market expectations after giving consideration to all conditions relevant at that time, including the economy in general and the business and industry of that entity in particular.
Surplus, unproductive or unrelated assets are valued separately and added to the value derived by capitalising the future maintainable earnings.
The Earnings Multiple methods are of a generic formula, where:
Enterprise Value = Capitalisation Multiple * Adjusted Earnings
The capitalisation of FME approach is appropriate where:
- The Adjusted Earnings is typically some proxy for cash flow that has been adjusted for non-operational items, one-off items or agreed adjustments to revenue or costs that reflect the standard of value being assessed.
- Depending on the circumstances of the valuation, the proxy used for cash flow will be historic EBIT or EBITDA or a forward-looking measure such as future maintainable earnings (FME), also represented by EBIT or EBITDA.
EBIT and EBITDA multiples (the inverse of the capitalisation rate) are commonly used in valuing businesses as a whole. Where an equity value is required, it is necessary to then deduct the value of interest bearing debt net of cash.
- The earnings of the business is sufficient to justify a value exceeding the value of the underlying assets.
- Where a relatively stable historical earnings pattern is demonstrated.
- The business operations are expected to continue indefinitely.
The benefit of this method is the ease of calculation and simplicity in deriving an indicative valuation. However this also contributes to the method’s disadvantages, which include:
The selection of a multiple should ideally be based on accurate comparison with other similar businesses, usually in the same region. However this information is not always readily available for SMEs.
- The method’s assumption that the risk level of a business’ earnings remains constant over time. In almost all business cases, cash flows in future years are always subject to significantly higher risk than cash flows in the following year.
- Significant variation of previous profits makes it difficult to select an appropriate indication of value moving forward. This disadvantage can be exacerbated by variations in accounting policy framework used to construct the EBITDA result. The key here is to ensure that EBITDA represents an “everyday ongoing” operational profit result, and does not include one-off cost or revenue items.
Discounted Cash Flow
This is a more complex version of the Earnings Multiple method and values the asset/ business by discounting net future cash inflows and outflows by an appropriate cost of capital.
This method requires:
This valuation method is generally more appropriate assets with a finite life or businesses that are forecasting significant growth or experience ‘lumpy’ volatile cash flows.
- Forecasting of cash flows over a period of at least five years (explicit projection period).
- An assessment of the cost of capital (discount rate).
- An assessment of the residual value of the asset remaining at the end of the explicit projection period.
The DCF value calculation evaluates the current value after tax cash flows associated with an explicit projection period (ATCF) and the current value of a terminal cash flow component (associated with ongoing operations of the business pas the explicit projection period). The basic formula is:
(ATCF i) TCF
Value = ∑ --------- + ---------
(1 + k) i (1 + k) n
- ATCF i: After tax cash flow for year i
- n: Final cash flow projection year
- k: Weighted average cost of capital
- TCF: Terminal cash flow
Asset Based Approach
This method considers an adjusted value of the assets and liabilities held by the associated entities to be representative of market value. The asset based valuation methods commonly used are:
The use of asset based methods is appropriate where the:
- Orderly realisation of assets:
- Under this method the asset is valued on the basis of its estimated realisable value after making due allowance for expected realization expenses and after all liabilities are extinguished.
- Going concern basis
- Unlike the previous method, this method assumes that the assets and liabilities of the business are transferred on a going concern basis. Therefore, no allowance is made for the costs of realizing the assets or extinguishing the liabilities.
- Enterprise is merely in a ‘holding’ situation and is not trading.
- Enterprise or business entity generates little or no income, so as not to be an attractive investment proposition from the willing buyer’s point of view.
- When compared to the investment in operating infrastructure, the business does not generate sufficient earnings to justify goodwill.
- Nature of the operations is such that it is not possible to make an estimate of maintainable earnings.
Cost Based Approach
Cost based methods are used to determine the cost the business would incur if it was deprived of the current assets and had to replace them in some way.
These methods consider the costs associated with creating (accumulated costs expended to date) or replacing the business (i.e. the cost to be incurred to replace the asset). They do not reflect future economic benefit.
These methods are typically used to reflect the value of assets that are not attracting sufficient profits to infer an appropriate value.
The value of your business is the single most important metric when considering how your investment has performed and what decisions you make on its future.
The value of your business incorporates profitability, capital investment and risk into a single measure that will reflect the and decisions changes that you make in your business.A valuation is critical when you are:
Without a clear assessment of the value of your business you are running blind when making critical strategic and management decisions.
- Buying a business or selling a business.
- Buying or selling to other owners or shareholders.
- Making a capital investment decision.
- Restructuring the business.
- Bringing in new investors.
- Managing tax issues.
- Resolving commercial disputes.
- Settling a divorce that involves a business.
Whether you are developing an exit strategy, improving your business or needing to meet compliance requirements, a business valuation will guide your to make better decisions.
Maxell Consulting has completed hundreds of business valuations and helped many businesses make value decisions that impact the future of their business.
Find out what your business is worth today.