The Science Behind Business Values

Valuations are valid at a given point in time. They are specific to purpose, employing appropriate and relevant valuation methodologies.

Valuation Methodologies

Valuation methodologies vary depending on their relevance. Common valuation methodologies include:

Comparative prices. Relevant to public companies, or real estate, rarely to closely held private businesses
Earnings approach. Many variations apply depending on circumstances.
Book value (reported and adjusted)
Present Value (PV) of cash flow and Internal Rate of Return (IRR)
Replacement value
Liquidation or realisable value
Industry value drivers (industry accepted multiples)

‘Comparative Prices’ - Limitations

The comparative prices approach is recognised as one of several determinants of value (willing buyer willing seller), used wherever possible, to narrow down an intersection of value coordinates.

However, rarely are comparative prices directly relevant to closely held private businesses.

Publically listed companies have daily trades. Not so with closely held private businesses.
Small businesses are rarely directly comparable (location, systems, management, market position, risk profiles…) .
Terms and circumstances of private company sales are dissimilar. Lack of transparency makes their evaluation impossible (confidentiality agreements buried deep in business files).

Transparency

Lack of transparency is an important constraint when using Comparative Pricing when appraising closely held private companies.

Comparative Pricing is available when valuing properties (property ratings ‘RT’ valuations, sales by location), as are trades in publicly listed companies.

In sales of closely held private businesses, such information is usually second hand and unverifiable. Without sighting transaction details, lack of transparency unfortunately makes it difficult to place much reliance on unverifiable claims.

Industry Value Drivers

Most industries have what the market calls “Industry Value Drivers”. These apply variously to business sales to existing businesses with existing infrastructure, supplementing existing incomes and profits.

Usually, these are based on trade accepted short cuts of multiples or percentages, to establish purchase price (e.g. 80% of sustainable income).

Industry specific Industry Value Drivers is a specialised business valuation approach. If used, it must be in the context of generally accepted valuation methodologies of justifying business value.

Justifying Business Value

Without transparent and verifiable directly comparable transactional information in closely held private companies, how is value established?

Fortunately there is a core and fundamental reality that underlies and supports business value.

Business value is justified only through its inherent power to generate ongoing income and acceptable returns on investment.
Where the inherent power of a business as a going concern is unable to generate acceptable returns on assets employed, then attention is inevitably refocused onto the realisable value of assets employed

There are many variations within established valuation methodologies and even more complexities applied, in calculating business values and its constituent components.

At its core, business value is based on expected ongoing return on investment. This is measured as a percentage of sustainable (net) income in relation to investment.

The level of return required by an investor reflects perceived risk, assessed primarily by the very sustainability of the ongoing income and the preservation (or growth) of the investment.

Value boils down to

Where:

V = Value
I = Net income that's sustainable. Growth is a consideration also
M = Multiple based on buyer (market) requirement of risk-return.

Income and Multiples

Income measures can include:

NPBT = Net profit before tax
NPAT = Net profit after tax
EBIT = Net profit before interest and tax
EBDITA = Earnings before depreciation, interest, taxation, and amortisation (generally of intangible assets such as good will).
PEBDITA = Home grown definition of normalised EBDITA. Normalised in this context makes an adjustment back for extra drawings of business owners, replacing these with normal cost of salaried employees.

Multiple measures include:

MULTIPLE = Often applied to NPBT in private companies. A multiple of 3, for example means an expected return on investment of 33%, a multiple of 4 means expected return on investment of 25%
PE = Price earnings ratio (relates to NPAT). Generally applies to Public companies. PE of 10 means for example, that the corporation price is 10 times the after tax profit delivered.
IRR = Rate of return, used in capital budgeting, to measure and compare the profitability of investments. It is also called the discounted cash flow rate of return (DCFROR) or simply the rate of return (ROR) In the context of savings and loans the IRR is also called the effective interest rate. The term internal refers to the fact that its calculation does not incorporate environmental factors (e.g. the interest rate or inflation). ROI (Return on investment) is a further related measure.
PV = Future income stream discounted to Present Value at a predetermined rate reflecting required returns.

Sustainability

While sustainable income is a driver of value, it’s very sustainability is a further crucial determinant of risk in the eyes of investors. It is perceived risk in combination with investors’ required level of return, that determine the multiples investors are prepared to pay for a business, as the party writing the cheque.

What makes income more or less sustainable?

Amongst many others, these factors include by way of example, the nature of the business, its industry, its market share and position within the industry (first, second or percentage of market share), the management team track record, future competition, threshold to entry (entry of new competitors), technology considerations etc.

Robust business systems for marketing and delivery of services or products are seen as key mitigants of risk.

Growth

Generally, investors will be adamant about ‘...not paying for future potential..’ However growth is without doubt, a key consideration for potential buyers or investors. The capacity of your business as it currently operates in order to generate existing levels of income, commensurate with the real potential to gain greater market share, serve to influence value calculations of investors.

Rate Of Return or Return on Risk (‘ROR’)

Whatever formula is employed, return on risk seeks to define the relationship between sustainable income and growth in relation to investment.

The higher the perceived risk, the higher the return required (and the lower the multiple paid).

Return on Risk

Whatever formula is employed, return on risk seeks to define the relationship between sustainable income and growth in relation to investment. The higher the perceived risk, the higher the return required (and the lower the multiple paid).

Multiple calculation

Investors are expected to require a return over normal business returns in an industry. For example, if the expected return is 18%, a potential investor will assess their perception of risk of a particular proposition, its appeal, and it’s fit for them.

Factoring in the various risk elements, might well add a further ‘Risk Safety Factor’ to the existing equation, for example, 13% to a potential investor’s return expectations, and willingness to part with their money. At 31% (18% + 13%) the potential investor’s multiple will become a maximum multiple of income (see above) of 3.2 (100% / 31%). They could commence negotiations at a multiple below 2.5

What multiple should the seller ask for? Settle for? What is the perception of risk of a particular proposal in the eyes of the buyer?