A valuation ahead of a sale will always be a theoretical exercise and the final valuation of the business is that which a willing purchaser is prepared to pay the vendor.
A vendor will only really get a feel for what the valuation is likely to achieve when conversations are initiated with purchasers and the level of interest in the business determined. Prices of companies in common with other prices are largely determined by the laws of supply and demand.
Nonetheless, a pre-sale valuation of a business can be an advisable component of the sales process.
There are several factors which will affect the value of a business, including:
- the company’s historic and projected financial performance;
- the attractiveness of the sector in which the company operates and the strength of its market position;
- the size of the company;
- the strength of its management team; and
- the company’s asset base.
During the course of negotiations with potential acquirers, a number of different valuation methodologies will be used to establish the range of prices within which to negotiate the sale. it is important for the adviser and the vendor to understand these methodologies and the issues that may arise.
Common valuation methodologies are outlined below.
Methods of valuation
Although there are a number of methods for valuing a company, the following two are the most utilised by acquirers:
- multiple of the normalised earnings and turnover using multiples from comparable quoted companies and transactions (typically favoured by trade buyers); and
- discounted cash flows (used by private equity houses).
Multiple of normalised earnings
This valuation methodology applies an appropriate multiple to the normalised earnings to capitalise those earnings into a value for the business. normalised earnings are a company’s reported pro ts adjusted for abnormal or non-recurring items.
Having established normalised earnings, the appropriate variant of earnings to multiples must be applied. The multiples normally applied are:
- Earnings Before interest and Tax (EBIT)
- Earnings Before interest, Tax, depreciation, Amortisation (EBITDA)
Care should be taken in selecting the appropriate earnings multiples to be applied, taking the following into consideration:
EBIT
Companies have different financial structures and, therefore, different interest costs and rates of taxation. The EBIT multiple is a pre-tax multiple and is considered by many to be a more appropriate multiple where a company has significant levels of debt.
EBITDA
In using an EBIT multiple, an assumption is being made that the depreciation charge for the year broadly equates to the company’s capital expenditure for that year. This could clearly not be the case, thus, the EBITDA multiple extends the EBIT assumptions to include differences due to financing arrangements for fixed assets and growth through acquisitions or organic growth by stripping out the effects of depreciation and amortisation.
PE ratio
The Pe ratio is the ratio of the market value of the equity of the company to its after-tax earnings. The Pe ratio focuses directly on profits available to equity holders, but its drawback is that it does not reflect differences in gearing, depreciation and amortisation.
It some cases, it is advisable to use the different types of earnings multiples to act as a counter check to each other.
Turnover, gross profit and contribution
In addition to the above more commonly applied earnings multiples, where profits are very low or non-existent, it may be appropriate to use multiples of gross profit, contribution or turnover.
Turnover multiples may also be used preferentially in certain sectors, such as technology and consumer brands, usually, where there is huge growth potential relative to the size and profitability of the business for sale.
Comparable companies
The earnings multiples applied are typically based on multiples of quoted companies that, ideally, are comparable in terms of activities, size, geographical location and financial performance. The multiples of the comparator companies are derived from quoted public companies, since only quoted companies have valuations which are readily accessible and which have been established by the market.
Once the comparable quoted public company multiples are identified, an appropriate discount should be applied if valuing a private company. On the average UK private companies are sold at a discount to quoted public companies though the level of this discount has reduced in recent years. it may be appropriate to reduce the discount applied due to particular strengths of the business such as growth, profile, market share and size.
Comparable transactions
in conjunction with multiples of quoted public companies, it is also useful to utilise the exit multiples of recently completed transactions in the same sector as the company to give an indication of pricing and trends in its market.
Discounted cash ow (dCF) valuations
The discounted cashflow methodology values a business by discounting the projected future free cash flows to the company, in order to arrive at a net present value (nPV) of those cash flows. The free cash flows are the residual cash amount after deducting all operating expenses, taxes and expenditures for maintenance of the business, but prior to deducting debt and equity financing payments.
The appropriate discount rate (or cost of capital) used to calculate the nPV will reflect the risks associated with the future cash flows. The discount rate is calculated by taking a weighted average cost of capital (WACC). The rationale for using a weighted average is that the assets of a business are financed through a combination of both debt and equity.
Estimating the costs of equity and debt are determined by reference to debt instruments and comparable quoted companies for which data is available. The higher the inherent risk of investment, the higher the required rate of return, and hence the discount rate, that will be applied.
Care should be taken in drawing conclusions from this methodology, as this valuation is heavily reliant on the company’s financial projections and even small changes in the discount rate and other assumptions could have a material effect on the valuation. As with all valuations reliant on projections, the result is only as good as the assumptions made.