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Value my business!
I am often asked “What’s the multiple for my business?”, “What’s the valuation formula?” or “Do I multiply my profit by three?”
Unfortunately, business valuation is not this simple. Business value does not stand independent of the market it operates in, nor is the value just based on the profits generated by a business. I have completed a number of valuations over the last few years, including for the crown under the Public Works Act. These valuations must always be completed as expert opinions, and some have included presenting and defending these at arbitration or mediation. Therefore preparing these valuations requires significant consideration of all components of the process of valuing a business. Below I share some of these considerations in a general sense.
Market Analysis (past, present and future)
This requires consideration of the market for the business products and services and whether the business is currently equipped or has strategies in place to deal with market trends and risks. Some questions requiring consideration are:
- Is there sufficient demand for all players in this market?
- Is there growth, stagnation or decline in this industry?
- Where is the market – domestic / International?
- Are there foreseeable changes in the delivery of the service / product?
- Is there existing or potential service / product substitute risk?
- What are the effective channels for delivery of the service / product?
- How would this market react in the event of an economic boom or bust?
This is similar to a SWOT (strengths, weaknesses, opportunities, threats) or ‘Porter’s 5 Forces’ analysis of the business. This will include strategies in place / required, to deal with the completed market analysis.
- Customers and suppliers; strength and protection of relationships, concentration, scarcity / scalability, ability to transition
- Scalability; resource capacity and constraints
- Operational efficiency; gross margins and overhead structure
- Staffing / turnover / key people
- Reliance and level of involvement of vendors / owners
- Warranties, guarantees and other contingencies
- Premises; location and lease terms
- Market response; evidence of, and strategies in place
The Earnings Figure
What is the earnings trend of the business, i.e. is there growth, is it stable, or is it declining? This will determine how many years are taken into account, and at what weighting, to represent the Future Maintainable Earnings (FME) figure. For example, if the business is growing, it could be that the weighting would be greater on the latest financial year, or on forecasts. Analysis is then required to adjust for any non-business related income/expenses, or account for any one-off spikes.
How much capital investment is required and how often? The most appropriate earnings measure must also be determined here. Is it EBIT (Earnings Before Interest and Tax) or EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation)? Proprietor salaries may also need adjustment depending on the valuation method used.
General Methods of Arriving at a Multiplier
This is a topic on its own so here I will refer generally.
Market Methodologies – Reference to statistics compiled by brokers of transacted business sales broken down into business type. These are largely small to medium enterprises and include remuneration received by the owners as part of the business earnings figure used. This is due to the fact that in businesses of this size, buyers are also effectively buying a job and a lifestyle. It is critical to understand that the information provided is just a collection of statistics. It is the market and business analysis of the subject business which determines how these statistics are adjusted and used to arrive at a supportable multiple.
Investment Methodologies– Views a business purchase as an investment and applies ‘rational’ investment theory. The discount rate is arrived at by reference to financial markets, either directly by referring to a comparable listed company, or by building up to a rate based on risk free rate, industry and business risk in comparison to the financial market as a whole. This requires the analysis on the market and the business to determine risk with reference to the financial markets.
The Bottom Line
Hopefully it has become clear that the multiplier or discount rate is effectively a measurement of the risk attached to a business’s earnings into the future. Regardless of which method is used to arrive at the multiplier, the business and market risk analysis is critical. It is entirely conceivable that two businesses operating in the same industry, having the same revenue and operating in the same area could have materially different multipliers and values. Increased risk of customer concentration, less favorable lease terms, and supplier risk not dealt with in one of these businesses would decrease the multiple used. The most critical aspect of a business valuation is understanding the business and the environment within which it operates. There is no ‘off the shelf’ multiplier based on your business category, nor is this the driver of value.
It follows that if you understand the market and business risks within your business – in conjunction with what the value drivers of your business are – you could build strategies to increase the value of the business, or more effectively drive it to your target exit strategy. The earlier you do this, the better. Understanding business value is key to succession planning. Stay tuned for our upcoming article on Succession Planning.