How to value a business

Jun. 21

Business valuation is one of the few disciplines in finance that combines both art and science. Indeed, a business’s value is determined by the application of various methodologies and a bit of judgment. This is why one business valuation method will differ from another.

Rules of thumb

Over the years, a concept has evolved to make decision making more accessible. This concept, better known as the "rule of thumb", is used by many to advance analysis and discussion.

However, a decision based on a simple rule of thumb is very dangerous for the following reasons:

Rules of thumb are based on past transactions that are no longer relevant as of the valuation date.
Rules of thumb do not take into consideration factors unique to the target asset or business.

Thus, the intrinsic value of a business determined by a rule of thumb may be significantly different and lead to an incorrect conclusion. It will not take into account the risk factors specific to the market value of the business

Approaches to business valuation

The first step on how to value a business is to determine which approach to take. There are two approaches:

Going concern: the business is viable.
Liquidation or cessation of activities: the business is no longer viable.

The conclusion will be different depending on the context. If the company is able to survive in the long term, an investor can expect a positive return on investment (ROI).

Business valuation methodologies

Earnings-based
- According to this method, the company generates positive and recurring profits. An investor could then expect a return on investment in the coming years. Moreover, since the present value is higher than the net asset value, we can exclude the asset-based method.
Asset-based
- According to this method, even if the company can generate maintainable profits, it is concluded that the value of its net assets is higher. This is especially the case for a real estate company, where the buildings held, after consideration of the loan payable, indicate the value.
Market-based
- Under this method, market metrics will be the determinants of value. By observing past transactions or using public companies, multiples can be applied.

In the case of an asset liquidation, two methodologies will be adopted:

Orderly liquidation
- In this case, there is no immediate internal or external pressure to sell the company. Thus, the company has a reasonable amount of time and can follow a normal process of preparation for the sale or transfer of the business.
Forced liquidation
- In this case, an immediate cessation of operations is forced. The liquidation is then done in a rapid manner. The seller is in a distressed situation and has much less negotiating power. The selling price is often more unfavorable.

The methodology based on profits

The discounted cash flow

This technique consists of considering the value of money over time. In particular, the EBITDA (Earnings Before Interest and Depreciation) will be used.

It will therefore be important to adequately project future cash flows over a period that will cover this change. It will be important to ensure that logical and supported assumptions are incorporated, particularly with respect to:

Sales growth
Fixed and variable cost growth
Additional investments
A terminal value, which is a value representing projected cash flows indefinitely.
Loans payable

The accumulation of cash flows and maintainable earnings

When future profits are constant for the next few years, this method can be applied. Indeed, when profits are constant each year, it is not necessary to perform a DCF.

This technique requires first adjusting or normalizing the company's historical results to arrive at maintainable results. For example, bonuses paid at rates that do not correspond to industry standards should be revised downward.

The asset-based methodology

Adjusted net assets or the asset-based method.

Under this technique, the assets and liabilities on the company's balance sheet are adjusted to their market value. Then, the adjusted liabilities such as bonds and other debts due to creditors are deducted from the adjusted assets. Finally, it is important to take into consideration the latent tax impacts to arrive at the value of the company.

The market-based methodology

Previous historical transactions

According to this technique, the appraiser will gather a sample of purchase or sale transactions involving companies comparable to the target being valued. He will then calculate different multiples that can be applied to the revenues or EBITDA of the company being valued.

Public company multiples

The advantage of this technique, unlike the previous transactions, is the availability of data.

The adjustment of private transaction multiples and public company multiples can be summarized in the following list:

Size and nature of the company used in terms of turnover
Inherent differences between a private and public company
Type of consideration received in exchange for the business transfer. A cash transaction will have higher multiples than a stock transaction because the cash is more favorable to the seller.

Business valuation techniques in a liquidation context

In a business liquidation, the disposition value of the assets and liabilities will be representative of the FMV. In such a context, it will be important to determine the market value of each of the available-for-sale assets.

Conclusion

To value a business requires discipline, experience and judgment. It is not enough to simply apply a multiple to revenues or earnings to determine fair market value. Rather, professional Chartered Business Valuators (CBVs) will combine these methodologies and techniques to corroborate each other.

In addition to the approaches and methodologies, the appraiser will also analyze the economic environment as well as the risks associated with the industry.