London, United Kingdom (PRWEB) February 25, 2008
It's not just another day on the nondescript trading estate in Slough, North London for Dave Blake. Dave has made a decision to sell his business and emigrate with his family to New Zealand, where his brother has already moved. Dave is the sole owner a small software company in a slow-growing market segment with revenues around £3m, growing 20% per annum.
Trouble is, like many business owners, Dave has no idea what value to put on his business. He has been given wildly differing business valuations from two business brokers and an accountant. Which one is right?
The Business Sale Report takes an in-depth analysis of the top business valuation approaches that are being used across international markets today.
Brokers, valuers and accountants use dozens of valuation methods, but the only one that ultimately holds true for a private company is the market-determined valuation. This is the price a buyer is willing to pay and that a seller will willingly accept for the business.
Potential buyers may have completely different reasons for purchasing the business. It may be that the buyer is specifically interested in the target's technology, for which a grander application is planned. Or its established distribution channels. Many venture capitalists and private equity houses perceive the management team to be the most important value driver. The market-led valuation approach implies that the methodology for valuing a business should be determined by the purpose behind the proposed purchase.
Although ultimately the most accurate, this approach is not overly useful in enabling business sellers to quantify their expectations.
Here are the three main approaches used today for justification of the setting of asking prices by vendors and offer prices by purchasers.
1. Asset valuation
An accounting-based approach that subtracts business liabilities from business assets to arrive at the business value.
Simple at first glance you might think; but is difficult to know what assets and liabilities to include and to place a standardised value on them. If an asset is not included on the balance sheet - let's say a unique proprietary technology process, then it will not be accounted for in the valuation. Though you can be assured a business will always be worth at least the value of its assets less its liabilities.
More problematic is that this approach does not take into account the profitability of a business, so its application is limited for the valuing of most solvent trading companies.
2. Discounted Cash Flow
The Discounted Cash Flow (DCF) approach is a technical valuation technique used with companies, which are moderate to high cash generators or are soon expected to be cash-generative. It looks at today's value (at a given rate of return) of the accumulated profits of the business over a number of years added to the value of the business in today's terms if it were sold at the end of this period (Terminal Value).
For an illustration of the DCF approach applied to Dave's software business, go to this Business Sale Report blog post.
So what are the problems with the DCF approach?
It is not easy to apply. To forecast the future cash flow of the business, a full financial model must be prepared. This needs some serious analysis of the business, the macro-economic environment, the legal and regulatory framework and the competitive landscape.
The residual or Terminal Value of the business, for which there are several calculation methodologies, still needs to be determined. The Terminal Value is either calculated using multiples from comparable firms, or it can be assessed by sticking to the DCF fundamentals. This is often called the "perpetuity method" and assumes a growth rate 'g' of a perpetual series of cash flows at the end of the period (5 years in the software company example).
See the full formula for calculating the business Terminal Value in the full business valuation article on the Business Sale Report blog.
The other problem the valuer is faced with is that if the current or expected market conditions are turbulent, forecasting cash flows maybe pure guesswork.
Here an attempt is made to extrapolate or interpolate the value of the business by using information collected on similar business sales in similar markets. This approach is the closest simulation of a true market-led valuation.
The market has paid £x for ABC; the market has also paid £y for DEF, therefore because of the similarities between ABC, DEF and YOURCO, we can estimate that there is a strong probability that YOURCO will fetch £z.
Certain industries have their own 'rules of thumb' that are commonly used as comparison standards. Usually these are profit multipliers for an industry sector within a country, but sometimes the rule is based on another variable peculiar to the industry i.e. barrelage in the pub sector, customer numbers for a mobile phone air-time provider. But just because a rule of thumb has been extensively used in the past does not mean that it is necessarily the right approach to take - particularly when the rule of thumb is based on a criteria other than net profitability.
The profit multiplier or price earnings ratio is a common business valuation guide used for established and profitable businesses. It saves having to deal with the forecasting issue when cash flows are difficult to predict. But this method should always be used with caution: two similar businesses with identical profits are not necessarily worth the same.
To see how this variance may occur, view the example of two hypothetical companies that operate in capital-intensive tech sector on the Businesses For Sale Blog.
Comparables valuation is a clearly useful approach when the right information is available on other companies that are known to be very similar. Unfortunately, this information is not always able to be collected. This approach is often used in industries with simple business models and where there are many players. Larger and more complex businesses have fewer matches for comparison.
In the absence of comparables, the profit multiplier technique is still widely used as a valuation yardstick. Private companies often sell for between 2.5 to 5x earnings (generally the higher the annual revenue, the higher the multiple). Why 2.5 to 5 times earnings? For buyers, this multiple represents getting their investment back in two and a half to five years from profits. That's equivalent to a projected annual return on investment between 20% and 40%. And this is type of return rate that encourages buyers to take the leap of faith to buy an existing business. See examples of UK Businesses For Sale.
Buyers will often use one or more of these approaches to see whether the result of the calculation falls close enough to the asking price to give it some validation.
These are the most prevalent valuation approaches used in the market. For a free no-obligation valuation of your business from our panel of expert valuers, just complete this short inquiry form.