The issue of valuing a business is about arriving at a value that represents the best price you can get at a given time. So how can you arrive at a reasonable asking price? Most businesses will request a valuation from their accountant or business broker.
There are four generally accepted methods for business valuation.
The capitalisation of future maintainable earnings method is the most common method for valuing an existing business, as it usually aligns reasonably well with the expectations of potential purchasers. This method involves dividing an estimate of future maintainable earnings by the capitalisation rate. Alternatively, the inverse of the capitalisation rate is the known as the Earnings Multiple, and as its name implies, the value of the business is quoted as a multiple of future maintainable earnings. The earnings multiples vary for businesses of different size within the same industry and between industries for businesses of the same size. The Price/Earnings ratio or PE is one example of an earnings multiple.
The discounted cash flow method looks at the forecasted cash flows and then applies a discount rate. The discount rate increases with the level of risk and takes into account any and all variations, as well as the period over which the cash flows occur. The discount rate increases as the level of uncertainty/risk increases. The discount rate is applied to the future cash flow and discounts it back to the present, to arrive at a value of the business in today’s dollars. The higher the discount factor for a given cash flow the lower the Net Present Value (NPV).
This method focuses, not on what a business earns but rather what a business owns. It considers the current value of the assets less the liabilities or debts that are owed. The notional realisable asset base is used to value the business as if it were to close down or not continue in its current form. By considering the net realisable value alone, it will result in understating the true worth of a going concern business.
To counter this, goodwill, which is the difference between the true worth of a business and the value of its net assets is factored into an operating business. Goodwill should take into account all of the intangible aspects of the business, such as: its earnings potential; reputation; and the relationships with customers and suppliers. The tricky bit in this approach is coming up with a value for ‘goodwill’.
The market based approach looks at businesses that operate in the same industries. If there are a sufficient number of sales examples to draw on, then a common rule-of-thumb valuation method can be applied: a multiple of earnings being one.
Other examples would be:
Combining valuation methods is generally not recommended. Income based methods are about the earnings potential of the business, which already take into account the assets and liabilities required to generate those earnings. How well those assets are utilised, in other words how efficiently have the owners used the assets to generate the earnings, can be through the Return on Equity (ROE), which is a measure of earning generated for the investment outlaid by the owners to buy those assets.
The asset based approach is about what the business owns, not what it earns, although the goodwill component is supposed to reflect the future potential of the business. The value of goodwill is often difficult to calculate. With an asset based approach, you will often hear terms such as ‘the net tangible asset value’ or ‘the written down value’ of a business. Although these terms can apply to a going concern they are often applied to businesses, which are no longer trading or are being broken up and the assets sold separately.
Comparing valuations by different methods can be useful, particularly when there is a high degree of uncertainty involved in assessing the worth of a business. By looking at the various calculated values, a potential buyer applies their own rationale to the purchase and determines the price they are willing to pay.
In cases where the business is closing down, looking at an earnings-based approach is obviously not an appropriate approach to adopt.
Where the asset base approach provides a higher value than an earnings-based method, the owner or potential buyer may consider that the business is overcapitalised, or
Where the DCF varies from an earnings multiple approach, the anomaly may lie in the underlying assumptions about future maintainable earnings and so would warrant a review of the assumptions made.
In cases, where there are two buyers wanting to buy the same business, the value ascribed to that business, by each buyer can be different, even when the same valuation method is employed. The difference lies, again, in the underlying assumptions used by each potential buyer to calculate the value. The assumptions are in turn a dependant on:
As a potential owner or investor it is important to realise that the fundamental business value rests on its ability to generate income for its owners into the future. If all things are equal, then the earnings multiple facilitates this. However, all things are rarely equal, and so variations in earnings multiples are inevitable. The essence of an earnings multiple valuation is that it enables an owner or investor to compare different investment opportunities based on the level of income each will generate.
It is the ability to make cross comparisons and see which best meets the earnings objectives of a potential buyer or investor that makes the earnings multiple so useful. It is no coincidence that the ValueMyBusiness-RMIT Index is based on this method.