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How to Value a Business
The secret to knowing what a
business is worth
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The secret to knowing what a business is worth
•
•
•
•
Many people
M
l will
ill assure you that
th t th
there are specific,
ifi scientific
i tifi ways tto value
l ab
business
i
and most people believe that this dark art is only known to the select few who are
paid vast sums of money for their services.
If you speak to accountants,
accountants business brokers
brokers, investors or venture capitalists they
can give you chapter and verse on how to apply some of the theories. They can tell
you about Enterprise Values, Discounted Cash Flows, Price/Earnings multiples, and
multipliers of Revenue, EBITDA, EBIT and PBT. The explanations will be filled with
jargon and after listening for 5 or 10 minutes you’ll be sitting there in a trance of
confusion.
Even senior corporate lawyers and experienced business people have it set in their
minds that those who advise on and buy businesses know exactly what they’re
they re talking
about and can use their skills to determine an exact valuation for what your business
is worth.
In reality, there’s
there s only one real measure of what a business is worth. There’s
There s only one
key that determines how much you will get for your business or anything else that you
want to sell. It’s the secret that gets continually overlooked and is the cause of much
stress and debate around the business world.
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What’s
What
s the secret?
•
•
•
The only
Th
l reall measure off what
h tab
business
i
iis worth
th is
i how
h
much
h someone else
l iis
willing to pay for it. It’s that simple. The value of a business is wholly determined by
the amount of money someone else would be willing to give acquire it.
Now although this is a simple,
Now,
simple and much overlooked secret
secret, it doesn’t
doesn t come without
its challenges.
The first major challenge is that the potential buyer often won’t reveal what they’re
reallyy willing
g to p
pay.
y This is all p
part of the negotiation
g
g
game,, and its happening
pp
g
everywhere from the haggling in a Moroccan souk to employees trying to negotiate a
salary increase. The object of the game is to find out the real limits of the other
person without causing offence or upset.
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The Combined Value
•
•
•
When someone is
Wh
i buying
b i a business,
b i
then
th they
th may be
b able
bl tto gett all
ll sorts
t off
additional value from it by combining it with their existing business. And this may
make it far more valuable to them that it would be to another buyer. If a business has
a product or service that they know they can introduce and sell to their existing
customers then it would be worth more to them than to a buyer who serves a different
market.
A smart buyer will insist that they’re not going to pay you for the extra value that
they’ll be bringing to the deal and that sounds like a logical justification. However, in
reality the smart buyer will be willing to buy at any price that still provides an overall
healthy profit for them.
The second major challenge is that the buyer will have to justify to their investors why
they are willing to pay a certain amount, and that’s much easier when it concurs with
the formulae and calculations mentioned earlier.
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So how does this help you?
•
•
•
•
You need
Y
d to
t understand
d t d what
h t th
the fi
financial
i l criteria
it i are so th
thatt you can k
know whether
h th
the value you want to pay for a business falls within an expected range. Applying all
the main criteria will give you a low end and high end valuation, with other values
falling between the two extreme. If the value you’re
you re considering falls outside of the
range of valuations (i.e. higher) then you will need a good justification for
shareholders, investors or lenders as to why you would be willing to pay a higher
price. Of course, if it’s your money you only have to justify this to yourself.
It may be down to valuable intellectual property, a strong management team, a loyal
customer base, valuable contracts or elements that protect the business by making it
hard for competitors to enter the market. All of these factors can help to increase the
value of your business.
business
Equally, a Seller will have to have valid justifications if they want to price their
business at a level outside of standard valuation ranges using the normal calculations.
Ultimately, the other key factor in valuing a business is what you want and what you
are willing to pay. And finding that out is the objective of the game for the Seller, so
you may not want to give it away too quickly.
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Key valuation factors
• These are the elements that will be used to determine a valuation
range for a company.
•
•
•
•
•
•
•
•
•
•
•
•
•
•
Cash & Cashflow
Future Cashflows
Debt vs. Equity
Discounted Future Cashflows (NPV)
Terminal Value/Continuing Value
Forecasting Accuracy
Cost of Capital (CAPM/WACC)
Return on Investment
Internal Rate of Return (IRR)
Revenue/Turnover Multiples
Profit Multiples
Balance Sheet
Value
Goodwill
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Cash & Cashflow
• Cash is the lifeblood of the business
• Businesses that can generate cash are
highly valued
• The
Th ultimate
li
goall iis positive
i i cashflow
hfl
• Buyers
uye s look
oo at current
cu e t cash
cas & cas
cashflow
o
and future cashflow
• Over
O
ti
time N
Nett P
Profit
fit and
dC
Cashflow
hfl
converge to the same figure
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Future Cashflow
• A buyer can see current the cash position and the historic cashflow
• Valuations will be determined by the future cashflow
• Key elements
• sustainable
i bl
• growing
• recurring
• secure
• What is the demand on the cashflow
• Equity
q y – return to shareholders
• Debt – return to debt providers
• Ratio will stay constant
• What has to ultimately be given back?
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Discounted Cash Flow (DCF)
• Takes the future cashflow projection
y moneyy
• States it in terms of today’s
• Assumes that cash in the future is worth less
than cash today
• Applies discount rate to each period’s cash
• Formula
F
l =
• C1/(1+r)+C2/(1+r)2 +C2/(1+r)2+ … +Cn/(1+r)n
• C = cashflow in period
r = discount rate
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Financial Measurement
• Cost of Capital – risk/return (WACC)
• Investors want a greater return for a greater risk
• Shares
Sh
((equity)
i ) can provide
id higher
hi h return than
h bank
b k savings
i
but with more risk
• Expressed
p
as a p
percentage
g – the amount yyou want to earn on
your investment
• Time value of Money
• Concept that £100 today is worth more than £100 in 1, 2 or 3
years
• Based on what
hat that money
mone could
co ld be doing in the period
before you get it or spend it
• Interest rates used are known as the discount factors
Discount Table
The Time Value of Money
How much is £100 worth in the future?
Interest Rate\Year
Year 1
Year 2
Year 3
Year 4
Year 5
Year 6
Year 7
Year 8
Year 9
Year 10
5% Rate
£95
£91
£86
£82
£78
£75
£71
£68
£64
£61
10% R t
10% Rate
£91
£83
£75
£68
£62
£56
£51
£47
£42
£39
15% Rate
£87
£76
£66
£57
£50
£43
£38
£33
£28
£25
20% Rate
£83
£69
£58
£48
£40
£33
£28
£23
£19
£16
25% Rate
£80
£64
£51
£41
£33
£26
£21
£17
£13
£11
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Terminal Value
•
•
•
•
•
•
Also known as Continuing Value
Discounted cashflow will not run indefinitelyy
Usually to end of business plan projections
Beyond this a continuing value is used
Net profit is used as approximation to cashflow
A value
l is d
determined
d as ffollows:
ll
Terminal Value= PAT/(WACC – g)
• PAT = Net profit after tax in final year of DCF
• WACC = Weighted Average Cost of Capital
• g = expected growth in free cashflow
• This value has to be discounted to current values
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WACC
•
•
•
•
Weighted
W
i h d Average
A
Cost
C
off C
Capital
i l
Also known as the discount rate
Based on the risk profile of the company
Formula =
•
•
•
•
Rf + β(Rm – Rf)
Rf = The risk free return rate
Rm = The market return rate
β = beta factor (covariance of share risk against the market)
• Varies by industry, sector and company
• It’s an approximation
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Shareholder Value
• Shareholders are looking for current return and
long term growth (either or both)
• Capital investment indicates ability to maintain
earnings and growth
• Price of shares indicates market expectations of
compan (P/E ratio)
company
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Other Valuation Measures
•
•
•
•
•
•
Return on Investment (ROI)
Return on Capital Employed (ROCE)
Internal Rate of Return (IRR)
Return on Equity (ROE)
Payback
Enterprise Value
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Financial Measurement
• Net present value (NPV)
• The discounted value of future cashflow in today’s terms
• Addition of each years cashflow, discounted at the
appropriate rate
• Internal
I t
l Rate
R t off R
Return
t
•
•
•
•
A crude measure of the return on the investment
A investment
An
i
t
t ttooll used
d ffor assessmentt
The discount rate at which the NPV is equal to zero
Unreliable for unusual cashflows
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Financial Measurement
• Payback
• The period it takes to recoup the money invested
• Number of years it takes to have a zero cashflow (money in =
money out)
• Discounted
Di
t d payback
b k
• The number of years it takes to have a zero discounted
cashflow
• Discounted money in = discounted money out
• Reflects the fact the expenditure
p
is usuallyy up-front
p
and
income lags
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Revenue Multipliers
• Revenue/Turnover
• Turnover = headline sales figures
• Revenue = what is actually earned from direct sale
• Multiples usually fall between 1 & 3
• Varies by industry, sector, business and
expectation
i
• Usually a “rule
rule of thumb
thumb” check
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Profit Multipliers
• Can
C b
be b
based
d on:•
•
•
•
•
PBIT – Profit Before Interest & Tax
PAT – Profit After Tax
EBIT – Earnings Before Interest & Tax
EBITDA – Earnings Before Interest, Tax, Depreciation and Amortisation
F
Free
Cash
C h Fl
Flow
• Can use Sector PE ratios for comparison
• (1
(1-g/r)/(k-g)
g/r)/(k g)
– g = long term growth rate in earnings and cashflow
– r = rate of return on new investment
– k = discount rate
• Rule of thumb check = e.g. 6 x EBIT
• Varies by industry, sector, business and expectation
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Balance Sheet
•
•
•
•
•
Sanity check on valuation
Does the business have valuable assets?
Are there significant debts?
What are the working capital requirements?
Are there significant intangible assets (goodwill
etc.)
t )
• What is the current cash position?
• Goodwill = the value over and above the net
assets that is paid for the company
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Value
• Definitions
• Present value of the company’s free cash flow +
present value of after-tax non-operating cashflow
• Present value of cashflow during explicit forecast
period + present value of cashflow after explicit
period
• Both
B th can b
be plus
l b
balance
l
sheet
h t ((nett assets)
t )
• Both can be plus further intangible elements
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Considerations for IPO/Sale
•
•
•
•
•
•
•
•
•
•
•
•
•
•
•
Efficiency Ratios (sales per employee)
Leverage ratios (debt to equity)
Interest coverage – the amount of earnings available to pay interest expense
Profit Margins (gross & net vs Industry)
Use of proceeds
Earnings ratio (% to net assets,% to sales)
Operating history
Operating base (regional, national, international)
Quantity, quality & experience of management
Product differentiation & innovation
Single or multiple products/services
Intellectual Property Rights & Patent rights
Emotion
Competition
Whatever the market is willing to pay!!!
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Valuation Approaches
•
•
•
•
Intrinsic Value = NPV of divi’s/cashflows
Relative Value = compare to similar co
co’ys
ys
Market Anticipation = look at market/ind.
Technical Analysis = based on share prices
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Value Drivers
• Businesses have 2 types
• Value creators = positive to cash
• Value destroyers = negative to cash
• Guess which ones we want!
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Shareholder Value
• Profit
• Basic measure of company’s performance – can be
manipulated
• Cash
• More
M
iindicative
di ti measure – certainly
t i l shows
h
poor performance
f
• Value
• A
Assets
t off th
the company – indication
i di ti off iinvestment,
t
t b
butt could
ld
be cash poor
• Investment
• Shows potential for future earning
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Shareholder Value
• Return
• Amount shareholders require for investing in shares
• Risk
• Probability that venture may fail – higher risk requires higher
return
• Gearing (debt/equity ratios)
• Debt
b is cheaper
h
b
but h
has ffixed
d payment profile;
f l equity investors
expect more in the long run for the risk they are taking
• Short term vs.
vs Long term
• Different types of investors
• Strategic – not an excuse for speculative investment
• Need to combine current position and future benefits
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Cost Benefit Analysis (1)
• C
Comparison
i
off the
h measurable
bl b
benefits
fi against
i
the
h
investment
• Cashflow
• Measure of the cash spent against the cash recouped
• Uses the time value of money
• Impact on Business
• Consideration of secondary impacts – migration/substitution
• Technological developments/changes
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Cost Benefit Analysis (2)
• Tangible benefits
• Actual measurable savings or income streams
• Intangible (valuing)
• Corporate PR, Market share, partnerships, research
• Alternative use
• Consideration of what assets could be used for, if a venture
d
does
nott work
k
• Consideration of the alternative use, and hence value, of
items consumed ((People,
p , assets,, money)
y)