Business valuation is a rather inexact science. Some aspect of it may even be referred to as an art, requiring imagination and forethought. But, even though it is a partially subjective field, business is hugely reliant on it as a starting point for a negotiation when any stake of it is up for an ownership change (either for sale, internal change or as options). Since businesses and business deals range vastly in size, scope and complexity there are many different ways to calculate and justify values for businesses. In this blog I will consider the principles behind some of these calculations and when one might apply them.
By definition, the value of a company is a price a willing buyer would be willing to pay to a willing seller for a company or share thereof. Since this price depends on the negotiated agreement between the buyer and seller it is a compromise between their respective views of the value a business has or can create. This means that the business may have different values to different buyers because of the influence they may have over its future potential. The smaller the influence a buyer has over a business’s potential (by virtue of the size of the stake they are buying or the decision making power they may have) and the more frequent a change of shares occurs, the more rigid and defined the price of the business.
Generally, businesses are bought- or invested in because investors want access to potential future income via one of the following routes:
• To finance a business with potential due to its innovative idea, good market and/or the credentials of involved parties.
• To save the time it would take (and avoid the risk) to build one up from the ground.
• To take over its customer base, intellectual property (including brands) and employees.
• To streamline or strengthen a business process by buying capacity or buying up competitors.
There are three general approaches to arriving at a value for a business. These are:
• Asset based valuations
• Market based valuations
• Income based valuations
Asset based Valuations
Asset based valuations set the value at the cumulative replacement value of the assets (excluding the amount still owed on them) the business requires for day to day running (at least) or those that are included in the sale. For most physical assets, finding a current replacement value is a relatively trivial exercise. Using depreciated values (from the company’s financials) would be extreme since accounting conventions generally allow assets to be written off much quicker than fair market value would, so adjustments need to be made when attempting to use this valuation from the financials (part of the process of “normalising” financials). To rely only on asset based valuations one would have to estimate the value of the intangible assets (such as brand or institutional knowledge) of a company. These are usually lumped into an “asset” value called “goodwill” and are largely subjective. A notable caveat to asset based valuations is that the buyer should have the right to sell the asset after the sale for the valuation to be meaningful. If they do not buy a controlling share this valuation may not be appropriate. Often, the current value of assets will be seen as the absolute minimum value a business should fetch.
Market based Valuations
Market based valuations rely on comparisons to the value of other businesses in the same market. Values are generally expressed as a “multiple” of sales or profit that is industry specific. This multiple is a factor that estimates (by means of averaging) market and business conditions and demand and supply (for businesses to be sold) in a particular industry. This immediately brings up the issues that no two businesses will ever be exactly comparable (perhaps excepting franchises) and that data for “multiples” needs to be extrapolated from available data. Getting multiples from listed companies is relatively easy (given their financials and stock price) but these generally need to be adjusted down for private companies due to the lack of liquidity (i.e. the demand for) in their shares. Data for private companies is also available from business brokers but this data is extrapolated from a small sample and is not reliably collected.
Income based Valuations
Income based valuations attempt to estimate the future income of a business. They then assume that the current value of the business is equal to an investment (at a specified level of risk) that would pay out a similar amount in the same time. That investment amount is the current value of the business. These methods require significant amounts of analysis of historical results and their associated market and business conditions. They then require assumptions of how the market will change in the future as well as the impact that this may have on a company. Other assumptions that have a major import on these analyses are:
• Interest and depreciation rates.
• Cost of capital (essentially the interest rates the company pays for its level of debt).
• The level of risk investment in the business exposes investors to (and the interest rate that would compensate for it).
• Future growth due to changes in the businesses structure or prospects.
Income based valuations are based on the most accurate models of the value a business can create (often calculated from normalised financials) but they inherently require many assumptions about the future and the level of risk for a company.
When do I use which business valuation method?
This leaves us with the question of when to apply which method of business valuation. Unfortunately there is no set answer for this. All evaluation methods have their merits and distractions and all give different answers to the ultimate value of a business. The valuation is thus dependent on the initiator of the valuation process. A business seller would want the highest possible value for their business. A business buyer would be aiming at the lowest possible value. Stock market investors look for a value that is higher than the current stock price while being justifiably representative of future movements.
The valuation also depends on the amount and type of available information and the size and status of the company in question.
The most complex and large businesses are often the easiest to get a relatively accurate value for. If businesses are listed, the price of their shares multiplied by the number of shares in issue (the market capitalisation or MCAP) will determine the value of the company (at least the portion of it which is floated on the stock exchange). This estimate of a company’s value is a representation of the average values that many buyers (and investment funds) and sellers ascribe to it. Most funds will spend significant resources analysing companies based on their financial data and forecasts (many of which are useful for the valuation of smaller companies though probably too labour and information intensive). Other investors influence the share prices through the mass effects of their incremental beliefs of the value of the company (i.e. mass psychology). The end result is a value that generally only varies a little from day to day. Investors “bet” on the cumulative effects of these daily variations (day trading) or on perceived value, which they think the market will eventually recognise (value investing).
When larger stakes are bought in listed businesses, pinning down a value becomes more challenging. The sale of a larger stake will allow the buyer more influence over the company (and its future value) and thus, the price will be negotiated. Rumours of sale of a listed company or larger part thereof will generally cause the share price to move towards the negotiated price as increased or decreased investor demand (generally depending on what the company is being bought for – expansion or liquidation) drives valuations and mass psychology.
The valuation of listed companies is generally done via a combination of valuation methods, the emphasis on which one depending on the industry the company is in. Investment companies will value companies in industries that are relatively mature and highly competitive (where companies are not likely to change the way they earn a living and growth is generally determined by the growth of the market rather than innovation) by income based methods. In industries that are capital intensive (such as manufacturing or mining), asset based valuations might form the basis of an analysis with an income based portion based on assessments of future projects or contracts. They would generally use market based comparisons (e.g. Price/Earnings ratios) to compare companies and help to inform investment decisions only.
Less sophisticated investors (individual investors – no offence intended) might use market based valuations like P/E- (Price/Earnings) or other ratio comparisons or (so-called) “technical” analysis (essentially betting with a stock prices movement momentum or other historical trends).
If the company which is up for sale is not listed there may be much less to go on as a starting point for a value. Previous share sales may not have happened or it may have been years prior to the current sales event and undoubtedly with the company at a different size and under different conditions. And even then, these previous sales may only be a tentative guideline and not representative of the value that a new buyer or investor might extract from a company. So where does one start?
The first question that needs to be asked is: At what stage of the business life cycle is the business? These stages are generally Start-up, Growth, Maturity and Decline followed up by either Rebirth or Death. Businesses in each of these stages have different properties which lend themselves to some valuation analyses better than others.
Companies in this phase of the business life cycle generally have no historical financial data to analyse. These companies also generally don’t have much of an asset base to base a valuation on. At best, if they are going into a competitive market, they can be compared to similar companies but generally their evaluations are based on forecasts of the market, and assumptions about the business idea and the capabilities of the business team. Forecasts are generally conservative and impossible to quantify accurately. The assumptions are subjective, insecure and qualitative. Thus, investing in these businesses presents the highest level of risk which means that investors will demand high returns on their investment. Therefore the valuation of a business at this stage has less to do with the eventual value the business might create and more to do with the amount of money it may require in the near future (from the sellers side) and the risk appetite of the investor (from the buyer). As a consequence, the difference in value between a seller and a buyer is likely to be high.
In the growth phase the business concept of the company is proven and its focus is on expanding to fill the demand for its products. It will be in the process of increasing its asset base which might mean that it has taken on more debt. Asset based valuations would thus not be appropriate due to higher liabilities. Such companies will also be reinvesting any potential profits (or even make a loss) to finance the expansion. Thus some market based valuations (especially multiples of profits in relation to costs) would be disadvantageous. The only real option to value such companies is to use income based valuations. However, since the level and rate of growth is less predictable than in mature companies (see below) income based valuations for these companies rely on less predictable forecasts which exposes potential investors to higher risks but also higher potential profits than mature businesses (though not nearly as high as start-ups). The valuations of sellers and buyers are likely to be closer than for start-ups but not as close as for mature companies.
Mature companies rely on maintaining the status quo. The business model has been proven to work and they have carved out a market segment. The growth of the company is dictated by the organic growth of the market and gains in profitability can only be made by reducing costs. These companies are generally asset rich and a large proportion of the company value will be in the value of the assets. They will also have significant historical data that can be used to estimate future cash flows, costs and profits. Thus asset based valuations will determine the bulk of the value while income based valuations will become more consistent and predictable. Buyers of companies in this market segment are looking for a (virtually) risk free investment with predictable returns. They will thus pay a premium. Though valuations are becoming more predictable (also between sellers and buyers valuations), market based valuations are still dubious because of the data they will be based on. Comparative industry data for sales of privately held companies is unreliably collected and limited. It should be noted that most listed companies fall into this phase of the business life cycle.
By definition, companies in this part of the business life cycle are struggling and their valuation will depend on whether they will be followed by rebirth or death. If the company is moving towards death, its last remaining value will be in its assets. Since it will have little or no future income, income based valuations will be meaningless. If the company is moving towards rebirth, the principles of start-up or growth valuations would apply (see earlier) with consideration for existing asset value. Companies in this part of the life cycle generally offer the best value for a buyer since they can be valued for their assets (which could be sold to recoup that value) but have the upside of a potential turnaround.
Businesses are valued for a different of reasons. For investors, they are valued to see if they can be bought cheaper than they are currently trading. They are hoping to make relatively small returns while keeping risks to a minimum.
For sellers and buyers of private businesses, they are valued as a starting point in a negotiation. As such, the function of the value is to bring the right people and businesses together. The sellers starting value determines the depth of the pockets of the buyers he attracts. Whether they see similar value in the business will be determined during the negotiation (See “Business Negotiation”) and will ultimately determine the fate of the business sale.