Insights – FAQ’s – How is my Business Valued? Valuation Methodology of Small – Medium Business.
A question was recently asked – How do you arrive at a value for a business? Most of the valuations that are performed by Alto Accounting & Advisory consist of valuing a small-medium business as a going-concern; as such this blog will be limited to discussion in this category alone.
What is being valued?
The first question generally being asked is are we performing a Business Valuation (commonly known as Enterprise value) or an Equity Valuation?
An enterprise valuation might be needed where a business is being sold and the vendor will keep the trading entity. In this situation, the Goodwill of the business, the IP, plus any Plant & Equipment might be sold as part of the sale agreement, however the vendor will retain the entity along with any liabilities (e.g. ATO debt & creditors) and non-trading assets (e.g. cash at bank & loans receivable)
With an equity valuation the underlying shares in the entity are valued and usually expressed as a $ per share value. The acquirer of any shares inherits an ownership proportion of the goodwill, and net assets of the company. Following the abolition of Stamp Duty on share transfers, we are seeing a greater number of business purchase transactions reflecting a share sale agreement rather than a straight business/asset sale.
Concept of Value
It is not possible to define value in a manner that would satisfy all circumstances. Value can have different meanings according to the circumstances in which it is used. The following concepts are commonly used in our valuation work and it is vital to get an understanding of the concept appropriate for each circumstance prior to beginning the valuation:
- Fair value: This is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the valuation date. The fair value definition has regard to specific considerations of those parties subject to the transaction, including but not limited to non-financial considerations.
- Liquidation or break-up value: In the event of an entity winding up its operations, the realisation of assets normally results in the assets not achieving the full value they would have realised had there been a much longer time frame in which to sell the assets. The lower value is referred to as the liquidation or break-up value and should approximately equal the value that would be obtained if the assets were sold by public auction.
- Intrinsic value: Intrinsic value is a concept based on the theoretical ‘true worth’ of an asset and is determined by its past record and potential earning power. Intrinsic value may exceed the value that could be realised by selling the asset.
- Market value: Market value (sometimes referred to as fair market value) is defined as the amount that could be negotiated in an open and unrestricted market between a knowledgeable, willing but not anxious buyer and a knowledgeable, willing but not anxious seller, acting at arm’s length. The market value definition disregards transactions motivated by non-financial considerations and other situations involving personal considerations, by assuming that it is an arm’s length transaction.
- Replacement value: This is the cost which would be incurred in replacing the existing asset with a new asset of the same type. In the case of a fixed asset, replacement cost would include delivery and installation costs.
- Special or strategic value: This reflects the higher price that a purchaser is prepared to pay in view of such factors as potential economies of scale, reduction in competition and the securing of a source of supply or outlet for products. The higher price (the additional value) is unique to that purchaser — the existence of this special value means that the purchaser is prepared to pay consideration over and above the value that other purchasers are prepared to pay.
For the purposes of this blog, we will focus on the value concept ‘Fair Market Value’ as this is the most common concept used in small-medium business valuations that Alto performs.
Determining a fair market value is normally achieved using one or more accepted valuation techniques. These techniques include but are not limited to:
- Net Present Value of the projected cash flows (Discounted Cash Flow Method)
- Industry market method
- Capitalisation of future maintainable earnings
- Net asset backing based on an orderly realisation of the assets
Discounted Cash Flow Method
The discounted cash flow method is normally considered the superior technical approach because it allows for fluctuations in future performance to be recognised. It also values the business on the basis of the future free cash flows generated. To utilise this methodology however requires reliable long term cash flow forecasts and for many small-medium sized businesses the presence of reliable forecasts are often not available.
Industry Market Method
The industry market method may be used in industry sectors where there are a relatively large number of participants, sale of these businesses occur on a frequent basis and where the sale price is known to the broader public. In these sectors, current market prices can be established for similar businesses and which allow for comparison with any features unique to the business under consideration. This can provide a basis for forming a reasonable market opinion. The Management Letting Rights and Accounting/Legal industry often use an industry market method to determine the value of a business.
Capitalisation of Future Maintainable Earnings
The capitalisation of future maintainable earnings is generally the most reliable methodology to employ for mature profitable businesses that exist in the small-medium size category. This method capitalises (via a multiplier/capitalisation rate) pre-tax earnings and establishes a value for the enterprise. This method requires the determination of the future maintainable earnings of the business, assessment of an appropriate capitalisation rate and valuation of any assets surplus to the core business. This method is commonly used in the valuation of businesses and is appropriate where there has been sufficient trading history to establish business continuity and where it is reasonable to expect that the value of the business is likely to exceed the underlying value of the net assets. Using a very basic example, a business valuation might be calculated in the following manner:
Net Profit/EBITDA (after addbacks): $500,000
Multiplier/Capitalisation Rate: 3 times
Business Value: $1,500,000 ($500,000 x 3)
Net Asset Backing
The net asset backing method, is generally considered to be inappropriate for valuing businesses under a going concern concept. This method assumes that the value of the business rests in its underlying assets and that the value of those assets as recorded in the financial statements of the company is a reasonable reflection of current value. Where a business holds significant amounts of fixed assets the valuation of those assets under a going concern concept may be at variance with their realisation value. Further, the net asset backing method ignores goodwill considerations or the value of intellectual property, unless this has been recorded in the financial statements. Because of these limitations, we will often use this method only as a check-test option or secondary valuation method to achieve a level of comfort in the primary valuation calculation.
Business valuations can be complex and variable with no ‘one size fits all’ approach that can be employed in the calculations. The concept of ‘addbacks’ (the addition and subtraction of income and expenses to arrive at a ‘normalised’ profit figure) is a further variable in valuations that rightly deserves its own analysis in a dedicated blog.
How Can Alto Help?
Murray and the Alto team can assist with valuation of business for business sale, for restructure or other purposes. To have your business valued or for a general discussion, contact Murray.
Author: Murray Kilpin – 0477 868 249