Valuing Private Businesses

The issue of valuing a business and components of a business are long standing.  The seller wants to get as much as possible, the buyer wants to pay as little as possible, and the value lies somewhere in between.  In very simple terms it is the best price you can get at a given time.  However this is not always reasonable, for example at a given time, there may be no buyers or investors that have expressed an interest, one should not therefore conclude that the business is worth nothing.  So how can you arrive at a reasonable asking price?
Most businesses will request a valuation from their accountant or business advisor.  There are four generally accepted methods for business valuation.

Valuing a going concern

The capitalization of future maintainable earnings method is the most common method for valuing an existing business in good order, as it usually aligns reasonably well with the expectations of potential purchasers.  This method involves multiplying an estimate of future maintainable earnings by the capitalization rate.  The capitalization rate varies between industries and businesses and is usually expressed as a multiple of earnings (the price/earnings ratio, or PE).

Valuing new businesses

The discounted cash flow method is usually used to value new or immature businesses or business in which there is considerable variation in income or expenditure expectations.  This method estimates future cash flows and then applies a discount rate.  The discount rate increases with the level of risk and the estimated time taken for the business to reach maintainable earnings.

Valuing the sum of the parts

The notional realization of assets is used to value a business which is not expected to continue in its current form.  This is the case where the potential purchasers are interested in utilizing only parts of the business, so that various elements of the business are purchased by different parties.  For example an agri-business may be dispersed in three separate sales: land; stock; and equipment.

Industry valuations

In some industries there are a sufficient number of business sales on an ongoing basis for a rule-of-thumb valuation to be applied to a business.  For example in publishing, magazines have historically been valued at around 6 times earnings and accounting practices have historically been valued at approximately 4 times earnings.

Combining valuation methods

Combining valuation methods is generally nonsense.  One cannot reasonably take a value based on an earnings multiple and then add the value of the assets – regardless of whether they are plant, stock, equipment or goodwill.  To illustrate this point, it is the equivalent of looking at the PE Ratio of a publicly listed company, multiplying the earnings by the ratio to obtain the value, then adding the net assets to arrive at the price. 

Comparing valuations by different methods

Comparing valuations by different methods can be quite informative, and a useful crosscheck of business value.  If one method reveals a higher valuation than another then it may reveal something about the business.  Here are some examples:

1. If the notional realization of assets valuation is greater than the earning multiple valuation it implies that the business is either over capitalized or underperforming.
2. If the discounted cash flow valuation is greater than the earnings multiple valuation it may imply that the business is expected to substantially increase profits.
3. If the industry valuation is less than the earnings multiple valuation it implies that the business is either over valued, or an industry leader.

Comparing valuations of different businesses

As a potential owner or investor it is important to realize 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 earnings multiple valuation is that it enables an owner or investor to compare different investment opportunities based on the level of income they will generate.  Other factors will also be considered, (many of which are discussed in the next chapter), which also accounts for some of the variation in earnings multiples between businesses and industries. However it is the ability to make cross comparisons that makes the earnings multiple so useful.  It is no coincidence that the publicly listed company equivalent, the PE Ratio, is so commonly used.  It is also why the BizExchange Index is based on this.