Business Valuation - Three Approaches

I got pitched a question last week from a principal of a software business.

He asked what were the most common valuation approaches used for valuing a small software company in a slow-growing market segment with revenues around £3m, growing 20% per annum. The company has good technology though not killer

We can come up with any number 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 for sale.

Potential buyers may have completely different reasons for purchasing the business. It may be that the buyer is specifically interested in the targets technology, for which a grander application is planned. Or its established distribution channels. Or its outstanding human resources. 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. So I'll take a quick look at some approaches used 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 - lets 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.

How might we apply this to the software company owner, if we knew his company generated cash and we decided to use this approach?

There are several ways to apply DCF. Here is an example where we shall project realistic cash returns for the next 5 years and discount them at a rate acceptable to an investor at 20%. So, let's say the projected earnings of this software company added up over the next 5 years came to £2m. At this discount rate, that £2m in 5 years is equivalent to £800k today.

We assess what the residual value of the company might be in 5 years time (apply an industry multiple to the average earnings in years 3,4 and 5 with a weighting to year 5). To make the calculation simple, let's say the residual value is £10m. Apply a discount of say 20% (well guess this is the acceptable investor rate of return) and you have a discounted residual value in today's terms of £4m. Add back in the discounted cash flow: £4m + £800k = £4.8m.

Some investment banks prefer to use the more scientific basis for calculating the discount rate: the weighted average of the costs of debt and equity capital. Here's an example. The business has post-tax cost of debt of 7% and an estimated cost of equity of 25%. It plans to raise capital 30% by way of debt and 70% by way of equity and computes the cost of capital at 19.6% as follows:

Capital Split Cost Weighted

Debt 30% 7% 2.1%


Equity 70% 25% 17.5%


Cost of Capital 19.6%


So what are the problems with the DCF approach?
It is not easy to apply! To forecast the future cash flow of the business, you are going to have to prepare a full financial model. This is going to need some serious analysis of the business, the macro-economic environment, the legal and regulatory framework and the competitive landscape.

To complete the equation, we still have to make a judgement on the residual or terminal value of the business, for which there are several calculation methodologies. The terminal value is sometimes determined using multiples from comparable firms.

Or we can assess a terminal value 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).

Tp = (CFp x (1+g))/r-g

Where:
Tp = the terminal value at the end of the period p
CFp = the projected cash flow in period p
r = the discount rate
g = the estimated future growth rate of the future cash flows beyond p

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.

Other complexities also come into play. To an extent the acquired companys future cash flows depends on the acquisition method and the purchase price. How is that? The acquired business's future cash flows are directly affected by the taxes it will pay. The taxes the company will pay depend on its taxable income. And the taxable income will partly depend on its taxable deductions for depreciation and the amortization of intangible assets. These deductions depend on the acquired company's tax basis for its assets, which in turn depend directly on the purchase price paid for the company.

3] Comparables Valuation
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 for setting prices for businesses for sale. 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, especially in the UK, when a business is both established and profitable. It saves us from having to deal with the forecasting issue when cash flows are difficult to predict. But always use this cheap and cheerful method with caution; the value you end up with may be substantially different to the figure produced by a business valuation expert with experience in your industry.

To see how this variance may occur, lets look at two hypothetical companies that operate in capital-intensive tech sector. Lets assume this sector uses a rule of thumb that estimates the value of a company as 6 times EBITDA. We will assume that these two businesses are identical in every way with the exception that one business has plant and equipment that is newer and more efficient, requiring much less re-investment in capital assets to sustain the business.

Company A and Company B both have EBITDA of £1m. Ostensibly, according to the industry rule of thumb, they are both worth the same at £6m. But Company A requires £200k of capital investment each year to sustain the business, whereas Company B needs only £50k. Would you not prefer to purchase the business with the higher cash flows? On close inspection it transpired that company B had substantially higher admin costs that could be trimmed right back upon acquisition giving the purchaser a much higher ROI.

Comparables valuation is a clearly useful approach when the right information is available on other companies that we know are similar in most respects. Unfortunately, this information is not always able to be collected. It is more often used in industries with simple business models and where there are many players. With larger and more complex business, there are fewer comparable companies.

However, in the absence of comparables, the profit multiplier technique is still widely used as a valuation yardstick. I often see private companies go up for sale for between 2.5 to 5x earnings (generally the higher the annual revenue, the higher the multiple). Why is it 2 1/2 to 5 times earnings? Well, to buyers, such a multiple represents getting their investment back in 2 and a half to 5 years from profits. That's equivalent to a projected annual return on investment between 20% and 40%. And this is the type of return rate that encourages buyers to take the leap of faith to buy an existing business.

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. If you are looking for more, you need only go to half a dozen business brokers or valuers and ask them to assess the value of the company and to explain to you how they get to the figure.

You will be amazed at the variances. As a special service to our Blog readers, we are offering a free business valuation from one of our in-house experts. Just complete our short valuation request form.

Share this article

Latest Businesses for Sale

View more businesses for sale