There are a number of methodologies available with which to value a business or the business assets in an entity (company, partnership, unit trust etc). The principal methodologies used are as follows:
• Capitalisation of earnings;
• Discounted cashflow;
• Asset based valuation; and
• Industry or market method.
Each of these methodologies is appropriate in certain circumstances. The decision as to which methodology to utilise generally depends on the methodology most commonly adopted in valuing the asset in question and the availability of appropriate information.
Capitalisation of Earnings
This method involves capitalising the earnings of a business at an appropriate multiple which reflects the risks underlying the earnings together with growth prospects. This methodology requires consideration of the following factors:
Estimation of future maintainable earnings having regard to historical and forecast operating results, abnormal or non-recurring items of income and expenditure and other factors including key industry risk factors, growth prospects and the general economic outlook.
Determination of an appropriate earnings multiple reflecting the risks inherent in the business, growth prospects and alternative investment opportunities. Earnings multiples are generally applied to Net Profit after Tax (NPAT) or earnings before interest and tax (“EBIT”).
Earnings multiples applied to NPAT are known as price earnings multiples and are commonly used in relation to listed public companies. Earnings multiples applied to EBIT are known as EBIT multiples and are commonly used in respect of companies comprising a number of businesses where debt cannot be precisely allocated or in acquisition scenarios where the purchaser is likely to control gearing.
Earnings multiples can also be applied to other measures of earnings including operating cashflow, earnings before depreciation, interest, tax, and earnings before depreciation, amortisation, interest and tax. These alternatives are not likely to lead to a valuation conclusion which is materially different to that derived from using NPAT or EBIT.
An assessment of any surplus assets and liabilities being those which are not essential to the generation of the future maintainable earnings.
This methodology is appropriate where a company or business has demonstrated a stable record of earnings that is expected to continue indefinitely. It is the most frequently applied methodology in valuing industrial companies.
Discounted Cashflow (DCF)
The DCF approach calculates the value of an entity by adding all of its future net cash flows discounted to their present value at an appropriate discount rate. The discount rate is usually calculated to represent the rate of return that investors might expect from their capital contribution, given the riskiness of the future cash flows and the cost of financing using debt instruments.
In addition to the periodic cash flows, a terminal value is included in the cash flow to represent the value of the entity at the end of the cash flow period. This amount is also discounted to its present value. The DCF approach is usually appropriate when:
• An entity does not have consistent historical earnings but where the company/asset is identified as being of value because of its capacity to generate future earnings; and
• Future cash flow forecasts can be made with a reasonable degree of certainty over a sufficiently long period of time.
Adjustments are then made for any surplus assets or liabilities of the entity.
Asset Based Valuation (‘ABV’)
ABV is used to estimate the market value of an entity based on the book value of its identifiable net assets. The ABV approach ignores the possibility that an entity’s value could exceed the book value of its net assets, however, when used in conjunction with other methods which determine the value of an entity to be greater than the book value of its net assets, it is also possible to arrive at a reliable estimate of the value of goodwill.
The ABV approach is most appropriate where the assets of an entity can be identified and it is possible, with a reasonable degree of accuracy, to determine the fair value of those identifiable assets.
Industry or Market Method
The industry or market method is used for a large number of small business and industries. This method applies a valuation approach which it assumes is consistent for all participants in the same industry. The method calculates value as a multiple of revenues, gross profit, net profit or some other easily calculated variable of the business. This multiple may be a specific number or a range to which some qualitative assessment needs to be applied.
Apart from the capitalisation of future maintainable earnings method, this is the most commonly used valuation approach for SMEs. From a valuation perspective it is criticised for the lack of science in the calculation and the absence of assessment of differential values between businesses in the same industry. Under this method arguably two businesses in the same sector with similar revenues can be valued at a similar level irrespective of the quality of the business and its profitability. In practice, some level of qualitative assessment overlays the base calculation.
The argument to support this methodology is that it seeks to approximate and reflect market value. If the true market value of a business is the value that will be agreed between a willing, informed but not too anxious seller and a willing, informed but not too anxious buyer – with the outcome being the market value, then the value that best approximates the market will be the best assessment of the business value.
For an industry method to exist, the industry is likely to have the following characteristics:
• a large number of participants in the industry
• there are frequent transactions in buying and selling businesses in the industry and there is a level of public information available
• businesses in the industry have a reasonably consistent business model
Once the value of a business is expressed in a range of possible values, the qualitative aspects of the business determines whether the value is toward the lower or upper end of the range. Key factors to consider when determining this include:
• level of current profitability
• history of profitability
• growth rate
• dependency on key customers
• general demographic of the client base
• dependency on suppliers and key staff
• industry risks, if any
• general economic risks
Beames & Associates are able to provide a full range of desktop review and valuation services for use by internal stakeholders, to complete and comprehensive valuations for distribution to Directors, Members, Auditors and external stakeholders
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