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Welcome to EMC’s Spring Valuation E-Series, a sequence of articles designed to give you an insight into business valuations in the current marketplace and how these can be maximised.
Valuing a business is not an exact science or art. It relies on applying a commercial view of the macro-economic marketplace to a specific industry and business, understanding the numerical trends and applying a discount for the risk.
Many people mistakenly think that the value of a business is solely in the balance sheet, but it is important to remember that the aim of a valuation is to ascertain its worth as an investment purchase either to sell on, combine with another asset or as a standalone asset paying future dividends. In practice it is often a combination of each of these.
You may have heard the phrase “a business is worth the amount a willing buyer is prepared to pay a willing vendor”. While this is undoubtedly the ultimate proof of a valuation, there are key principles that underpin this. These are different for each sector and type of business, and understanding where a business fits is the first important step. We will discuss sectors in the second instalment of our mini-series, but first we will consider the main methodologies that can be applied.
Cost Model
This model is most appropriate when a trading business is asset intensive. Instead of considering the future cash in-flows that these assets could generate, their value is in their replacement cost. You will commonly see this approach used in sectors such as property or where a trading business has no value going forward (i.e. it is no longer considered a going concern).
Market Model
This model is most applicable for trading profitable businesses where comparisons can be drawn to similar businesses. Here the aim is to determine the business’s underlying future maintainable earnings and a rate that reflects the risks of delivering these.
This approach is similar to how you would consider going about valuing a house. Firstly, you find similar houses that have sold on the same road, then review the valuations that they achieved and compare how the valuation would be adjusted for the differences between the properties. In practice though the comparison of trading businesses is much trickier as the majority of deals are for an undisclosed consideration and, where announced, profits are often suppressed by various owner-managed expenses.
Income Model
The income model represents a more ‘traditional’ investment approach. The valuation is typically achieved by reviewing a forecast cash flow or profit and loss and then applying a discount rate to each cash flow to give a present value.
This valuation is more applicable where a company is growing and is often used by investment companies for this reason. Discount rate factors can vary by industry and investment appetite but need to include market conditions and specific industry risks.
While these three models will apply to many businesses, it is not an exhaustive list. For example, in sectors where there is recurring revenue (e.g. telecoms), there are often specific metrics to be used such as a multiple of revenue. In these sectors the nature of the recurring revenue streams means that the marginal benefit to a new strategic buyer can quite easily be forecast.
Another approach, often seen in sectors where customers can easily switch providers and start-up costs are low, is Entry Cost. In these cases, a business’s sale price valuation can be diminished.
If you have any queries or need advice, EMC’s valuation team are available to discuss with you on a strictly confidential basis. Call us on 01273 945984.
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