Valuing the Business
Valuing the Business
1 FACTORS AFFECTING THE VALUE OF ANY BUSINESS
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Source: HMRC Share Valuation Manual – Factors in the valuation of unquoted shares
In addition, any potential purchaser will also consider
• Strategic fit
• Succession & stability of senior management team
• Quality of systems and management information
• Culture, especially if a merged operation will result
• Quality of customer base and spread
• Goodwill incl loyalty of staff and customers
• Historic growth and future anticipated growth
• Expected sector developments & innovation
• Territory & market share
2 should you carry out a formal valuation?
Formal valuations will always be different to the actual offers received, since every purchaser’s view of risk and acceptable return will vary, due to their own unique circumstances, plans for the business and financing options.
A formal valuation can only be considered an indication at best, and at worst can be completely misleading to a client. Therefore you should always stress to clients that any valuation exercise is not an exact science, and in that regard, a formal ‘paper’ valuation should not always be carried out.
However, valuations can be useful, and should be used in 2 circumstances:
• where your client has no idea at all of how much his business is worth (usually where they are too optimistic) and they can be used to explain the mechanics of how a purchaser may calculate the business’s value;
• where you have been instructed by a client to ‘groom’ the business for sale, and you have been given at least 18 months to increase the value, before any disposal process is undertaken – the valuation is then used as a baseline upon which to measure improvements
If you are required to carry out a formal valuation, you will first need to decide which valuation method is the most appropriate to use.
3 METHODS OF VALUATION
Check whether the Articles of Association specify a basis of valuation. Usually they just require that the basis of the valuation will be ‘fair market value’. For this purpose we define market value as the price which the company might reasonably be expected to fetch, in money or money’s worth, in a sale between a willing buyer and a willing seller, each of whom is deemed to be acting for self-interest and gain, and both of whom are equally well informed about the Company and the markets within which it operates. You usually also assume that the Company will continue to operate as a going concern under its present management.
You must point out to your client that the valuation of shares in unquoted companies is not an exact science and, whilst your valuation will be one which you consider to be reasonable, others may place a different value on the shares. Different purchasers/investors will consider how risky the acquisition/investment will be for them and their particular circumstances.
There are several methods of valuation to calculate ‘fair market value’, and you need to consider which the most appropriate method is, or use alternative methods and take the average of the results.
1. Earnings - Earnings valuation involves the application of a multiple to the business’ maintainable earnings. This methodology would generally be used in the case of valuations of businesses or shareholdings that are mature companies (ie not start up companies), with non-cyclical earnings. See Appendix A for a worked example, along with further comments later.
2. Asset - Asset based valuations are generally used when a company’s main purpose is that of holding assets for investment purposes or where the business is stable and asset-rich, eg investment properties, farming or property development. Assets are revalued to present market values if a going concern is assumed, or a break up basis if the business is to be liquidated. Intangible assets and assets not recognised on the balance sheet such be valued and included, such as goodwill.
3. Dividend yield - Dividend yield is the income return to shareholders expressed as a percentage of the amount invested. It is usually only applicable to the valuation of non-strategic minority shareholdings, where the shareholder has no influence in the company, and relies on whatever dividends the controlling shareholders choose to pay out.
4. Discounted Cashflow - This valuation uses a business’ projected cashflows and discounts them to present values using an appropriate cost of capital for the purchaser/investor. This is particularly useful method of valuation where the past and future earnings are uneven, where the business has minimal historical trading results or where significant investment is required in order to bring the business to a profitable situation.
5. Accepted industry methods - Researching trade publications or keynote reports will identify if there are any accepted valuation methods in your client’s sector. For example, childcare nurseries are valued according to a multiple of registered places, residential care homes on registered beds, mobile phone airtime providers on number of customers, restaurants on number of covers and some small retail operations (hairdressers, newsagents, public houses etc) are valued on a multiple of sales.
Most owner-managed and family businesses will be valued on the ‘earnings’ method, possibly in conjunction with the ‘assets’ method if they have significant assets (such as land & freehold property) on the balance sheet.
4 MECHANICS OF PREPARING A VALUATION BASED UPON EARNINGS METHOD
The starting point
To calculate the ‘maintainable earnings’, the starting point is usually EBITDA (earnings before interest, tax, depreciation & amortisation).
Using EBITDA ensures that any differences between the private company and the public quoted companies in debt, investment and depreciation/capitalisation policies, are removed. It also ensures that any variances in the tax system and tax rates over a period of time, do not affect the underlying valuation or provide a misleading result.
Which earnings figures to use?
Ideally several years’ of historical profit & loss accounts, plus current year management accounts and at least one year of projected figures. After adjusting for non-recurring, exceptional or extraordinary items (see below), an average of the adjusted profits is taken. A weighting may be applied to the adjusted profits figures if this is thought more appropriate than calculating a mean average (eg if the more recent results bear more resemblance to expected future results)
If the business is loss-making, you should consider the reason for the losses and the future outlook of the business. If you consider that the business will return to profits and is a going concern, then use projected figures and continue to calculate using ‘earnings’ method. If however you believe that the business will continue to be loss-making, value using the ‘asset’ method on a break-up basis.
Examples of adjusting items
• Excessive directors’ (or key managers) remuneration, benefits, pensions etc, over and above market rates for that industry/role
• Personal expenses
• Large one-off bad debt provisions/write-offs or write-backs, large repair costs, insurance claims
• Imputed market rent charges if the business currently owns the premises it operates from
• Imputed rental costs of other fixed assets if material
Calculating tax charge
The calculation of the average profits represents the ‘maintainable earnings pre-tax’. A post-tax figure is required before applying any multiple as most P/E ratios are quoted ‘post-tax’.
The current corporation tax rate for that level of profits will be applied, and deducted from the average pre-tax profits to arrive at ‘maintainable earnings post-tax’.
Finding a suitable multiple
Some research is required for this, and there are several potential sources to investigate:
• Find the most appropriate FTSE category, or a quoted company in a similar sector (although this is often difficult as many family/owner managed businesses are niche operations) and discount accordingly.
Research has been carried out by ‘Acquisitions Monthly’ that shows that the P/E ratio for private companies (avg deal size £15m) is between 20% and 40% (currently 35%) lower than those of public listed companies. This research is carried out quarterly and is called the Private Company Price Index (PCPI). At Winter 2005 this showed that the average P/E of a private company was 13.1, however this was for larger deals than general practitioners may usually come across, and a further discount is suggested for smaller deals.
However, according to HMRC, the discount to be applied to the multiple of a quoted company to arrive at a suitable multiple for an unquoted company, is 50-75%.
• Identify a recent transaction in a similar sector, and obtain the P/E ratio actually obtained.
(use Acquisitions Monthly (acquisitions-) or
CorpFin (corpfinworldwide.co.uk), review trade magazines/press releases or general awareness in the industry)
• Consider whether higher multiples could be awarded if the business is unusually well-run and systemised, has guaranteed future profits or any other factor that may significantly reduce the risk for any purchaser
• After all potential multiples have been investigated, an average or weighted-average should be taken, before being applied to the ‘maintainable earnings’ figure.
The valuation
If the company’s balance sheet contains considerable assets (eg property) these may then be added to the earnings valuation calculated above, if they are being sold along with the trading business.
Further discounts may need to be applied if less than a 100% shareholding is being sold.
5 DISCOUNTS FOR LESS THAN 100% HOLDINGS
If you are required to value a shareholding which is less than 100%, you should consider the level of control and the influence that the shareholder is able to play in the running of the business. You should also review the Memorandum & Articles of Association to check if there are any provisions for casting votes, which may reduce influence further than the normal expected position.
For trading companies, guidelines for additional discounts at various levels of holdings are below:
Shareholding Likely influence Discount
0 - 25% minority interest, relying on dividends 40% - 60%+
25% - 50% influential minority interest 25% - 40%
50% active part, but not control 20% - 30%
50% - 75% day to day control 5% - 15%
75% - 99.9% absolute control 0 – 5%
Appendix A – Worked example of a valuation using Earnings Method
Valuation of 100% shareholding in company that supplies and sells pressurised cylinders.
| | |9 m/e 31 Dec |y/e 31 March |y/e 31 March |y/e 31 March |y/e 31 March |
| | |05 |04 |03 |02 |01 |
| | | | | | | |
|Profit before interest, tax, depreciation (EBITDA) | |26000 |40,801 |(10,581) |55,909 |68,804 |
| | | | | | | |
|Add back: | | | | | | |
| | | | | | | |
|Bad debts | | | |11,699 | | |
|Excess remuneration/pensions | |15000 |30,000 |10,000 |20,000 |25,000 |
|Costs of fire damage | | | |55,000 | | |
| | | | | | | |
|Less: | | | | | | |
| | | | | | | |
|Insurance claim | | |(38,000) | | | |
|Imputed rental charge | |(22,500) |(30,000) |(30,000) |(30,000) |(30,000) |
| | | | | | | |
|Adjusted profits | |18,500 |2,801 |36,118 |45,909 |63,804 |
| | | | | | | |
|Average profits over 4.75 years |35,186 | | | | | |
|Corporation tax @ 19% |6,685 | | | | | |
|Earnings post tax |28,501 | | | | | |
| | | | | | | |
| | | | | | | |
|P/E multiples (post tax) FTSE Industry Sectors |
| | | | | | | |
|Engineering & Machinery |12.58 | | | | | |
|Construction & Building Materials |9.28 | | | | | |
| | | | | | | |
|Average |10.93 | | | | | |
| | | | | | | |
| | | | | | | |
|Discounted by 50% for unquoted shares |5.47 | | | | | |
| | | | | | | |
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|Valuation | | | | | | |
|Post tax earnings x multiple | | | | | | |
|£28,501 x 5.47 |£155,900 | | | | | |
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