Last week, Kevin Lovewell stressed the importance of undergoing a business valuation, noting how the large share of business value today is based on intangibles off the balance sheet. Here in Part Two, he reviews the specific methods for performing a valuation based on one of two measurements: the physical assets of the company and the cash flows the company provides to the owners.
Valuation based on the physical assets of the business
Valuation based on the assets of the company is relatively straightforward.
This method is the “tried and true” method: objective, proven and certain.
However, it is also prone to significant understatement. As intangible assets become the dominant driver of value in the business, the valuation method based solely on assets will be less likely to be relied upon by buyers and sellers.
So why do Banks still use this method? Security! Banks are very risk averse and they can seldom sell an intangible if called upon to do so as a result of business closure.
Book value represents the application of traditional accounting concepts. The term refers to the purchase or acquisition cost of an asset less any accumulated depreciation for that asset.
However when attempting to determine business value, “Book Value” is expanded to include all assets, less their accumulated depreciation and also less any liabilities. The short hand version is as follows:\
Assets less Liabilities equals Owners Equity [A – L = OE].
This is also referred to as “Equity”.
Benefits of using Book Value or Equity
- Simple to calculate.
- Tangible assets can be touched, sold, used.
- The assumption that the assets of a company are actually worth the cash that was spent on them can be wildly inaccurate. That’s one reason why we deduct accumulated depreciation.
- We know that the value of the assets owned or held by a company does not reflect true value.
Where this knowledge is useful
Analysts refer to equity when forming comparative views. Examples are financial and value ratios.
Adjusted Book Value
There are many valid reasons to argue that book value does not reflect actual or even the realisable value of the assets in question, and consequently the book value should be “adjusted” up or down.
For example, property (generally but not exclusively) appreciates in value over time. As a consequence, making allowance for the changes in value (increases and decreases) can be justified in certain circumstances.
Another way of “adjusting” the book value of assets is to reflect the value of “intangibles” such as Goodwill, value of the company brand or patents and copyrights.
A third way of determining adjusted value is to consider what the market may pay at a “salvage” auction. Generally this is much less than even market value – everybody wants a bargain. This method is also known to many as “Fire Sale” price.
When consistently applied over time, adjustments help business owners determine with greater certainty true “realisable value” for assets or classes of assets.
Adjustments can be made for changes in value over time (both appreciation and depreciation). A practical example of these “adjustments” is the willingness of accountants (normally very conservative professionals) to systematically adjust the books to recognise changes in risk, technology, value of the dollar, or for changes in wear and tear of assets.
Due to the fact that any “adjusting” is based upon opinion, this method is always going to be open to debate and will rarely be accepted by opposing parties.
Valuation based on cash flow
The second category of valuation methods are made with reference to valuations based upon the profit-making potential of the business – sometimes referred to as cash flow methods.
Multiple of Earnings or Income Approach
This method is by far the most well known and easiest method to understand. It is used by real estate agents and accountants as a “rule of thumb” method for providing guidance.
The starting point is to ascertain the profit before tax for a twelve-month trading period. The method then multiplies that figure by anything from two times to nine times and even higher.
Example: let’s say a small sandwich bar and lunchtime coffee shop returned a profit of $30,000 for a year. If we used a multiplier of say three times (3 x $30,000) the value of the shop would be $90,000.
This method is simple and straightforward. The debate occurs when owners who want the best sale price attempt to bump up the multiplier to 4, 5 or more. Or alternatively attempt to add back their wages, or interest, or even suggest that they take most of the money out in cash or consumables so the profit figure should be inflated by these sums.
- The “rule of thumb” is debatable, seldom being accepted without encouragement to take into consideration (once again) the intangibles like location, access to clients, newness, etc.
- Vagueness in interpretation.
When dealing with investors who are active in the stock market, this phrase (earnings multiples) has a different meaning, so it is important to be clear on what you mean when you use this expression.
Discounted Future Earnings
This method approaches valuation by assuming the business will continue to operate, and will year after year make profits (and sometimes losses). Secondly, that these future profits or earnings must reasonably be converted into today’s monetary equivalent to arrive at a true value.
By adding up or summing all future period profit (loss) and applying a discount rate to convert the future into today’s equivalent dollar value, business value can be determined.
The method takes into consideration the “time value of money”; i.e. any business investor would prefer to have the money today, rather than at some future time. The calculation “compensates” the investor for the time span involved.
The method permits the incorporation of a “risk premium”. For example, as an investor looks further and further into the future there is an increasing risk that the planned future earnings will not happen. The discount rate allows for this uncertainty (or risk) to be built into the valuation.
The risk premium is a balance of opinion and fact and can be hotly disputed by opposing sides.
Discounted cash flow
As with discounted future earnings, pure (actual) cash flows are estimated to continue to occur in the future, and when converted into today’s cash equivalent, can assist in estimating the value of a business.
This valuation method is generally used when attempting to value new businesses. A company that is presently selling product or services has some accounting evidence to provide certainty in respect of revenue, costs and net profit. A new business however has significant uncertainty in respect for the assumptions made leading up to “profit”. Therefore using only cash flow, some of the uncertain assumptions are eliminated.
As with Discounted future earnings, the method is based on opinion, and risk. Significant debate can and does occur between parties on exactly how much to “discount” the numbers provided within the cash flow forecasts.
Using the “Capitalised Earnings” approach is the most difficult to use, and to explain.
Firstly it is necessary to work out the rate of return (interest rate) that will be used to reflect the business owner’s risk. Then the earnings are divided by that capitalised rate. The difficulties arrive in explaining the variety of mathematical formulas used for determining the rate, and then the earnings.
The more risky the business, the industry and even the broader economy, the higher is the required rate of return that should be used.
Similarly the calculation of the “true” income and costs can become quite complex. For example income can be adjusted to reflect “free” cash flow, profit before tax, after tax, or before dividends or after dividends.
The true carrying value of the assets being used to actually earn the revenue is also open for debate. What should or should not be included is dependent upon the bias of the “expert” providing the opinions.
Now that you know the most practical valuation methods and the caveats of using each, we can touch upon the last requirements of the assessment process. In the final instalment, we’ll focus on the key financial ratios and explain their importance to a business valuation.
Kevin Lovewell is the owner of Corporate Solutions (Aust) Pty Ltd, a Fellow of the Institute for Independent Business and a CMT accredited Master Mentor.
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