In this article, Lauren Dale, Senior Analyst in our Disputes, Investigations and Valuations team discusses the three different approaches to valuing a business and the aspects of each.
I don’t have a business, but if I did, I could picture myself pondering the above on my yacht that I tastefully named after my cat...
For most small and medium enterprises (SMEs), the valuation process can be complex due to a lack of publicly available information that exists in relation to listed companies. SMEs require detailed analysis in order to determine the value of the business that a reasonable third party would pay. There is no ‘one size fits all’ valuation method, instead there are a number of common techniques used when determining the value of a business, which I will discuss in this article.
Earnings based valuation (Market approach)
An earnings-based valuation is designed to value a business based on the maintainable level of earnings that is likely to be achieved in the future. A market derived multiple is then applied to those maintainable earnings to arrive at the Enterprise Value of the business (the capitalised value of those earnings).
“A multiple?”, I hear you ask. “Do we simply times the future earnings by 6 or 7?”
An appropriate multiple can be identified by looking at recent transactions involving similar companies to the business being valued (or trading multiples for listed comparable companies), to assess what multiple of earnings third party buyers actually paid. Key factors to consider are:
- Industry and business activity
- Size of the business – the risk profile of listed companies is going to be different to SMEs
- Geographical location – market sentiment can differ by geographical location
- Number of shares purchased – a total/majority acquisition is likely to be a more appropriate basis from which to derive an implied multiple than the sale of a minority of shares, owing to the potential for discounts for lack of control having been applied
It’s also important to consider whether earnings are dependent on the current owner or a single customer. A business like this will often receive a lower multiple than a business which achieves recurring earnings with a low dependency (as they aren’t purchasing you or your key customer relationship).
Discounted cash flow (Income approach)
If the company is reasonably sophisticated and produces reliable medium to long term cash flow forecasts, then a Discounted Cash Flow (DCF) method can be used to calculate the present value (adjusted to consider the time value of money) of the future expected cash flows, discounted back to the valuation date.
DCF valuations rely on a number of assumptions and estimates such as:
- Forecasted future trading results for the business
- Capital expenditure
- A discount rate factoring in the risks applicable to the cashflows
Changes in the estimates relied upon can significantly change the outcome of the model, and therefore this method is often used alongside market based approaches.
Asset based valuation (Cost approach)
Where a business is asset intensive, for example a real estate business, then its value can be derived from the fair value of its assets.
This typically includes:
- Fair value of property, plant and equipment
- Inventory
- Other working capital balances
- Less outstanding liabilities
This valuation method relies less on estimates which require professional judgement. However, it is important to know the value of the assets owned by the business.
The cost approach is less appropriate for profitable trading businesses such as those that are service or knowledge driven.
Conclusion
Ultimately, valuing a business isn’t about picking a random multiple while lounging on a yacht. It’s about understanding what a willing third party would genuinely pay, based on risk, sustainability of earnings, asset backing, and future cash flow potential.
So, while most SMEs may not benefit from listed market prices, with meaningful analysis and the appropriate valuation methodology, their true worth can still be confidently determined (yacht daydreams optional).
