We all know New Zealand is a country with a high number of small to medium businesses (SMEs). This may mean we are entrepreneurial, value working on our own terms rather than those dictated by employers, wish to utilise our skills or turn our ideas into action or a myriad of other options.
How then do we value these businesses with characteristics specific to New Zealand business context and culture?
Can we apply traditional investment methodologies such as Weighted Average Cost of Capital?
Essentially WACC attempts to estimate the return that debt and equity providers expect for their investment. How? Well, debt is easy as we can observe bank lending interest rates. Estimating the required rate of return equity providers require takes a stepped risk approach. Essentially, the premise is that equity providers would require the return for investing in a relatively risk free asset such as government bonds, plus an additional market risk premium for investing in the listed market, multiplied by the relative risk for a specific listed company as measured against the market. This relative risk is known as ‘Beta’. To delve more into the technical aspects of these – please refer to an earlier article by Bruce, Joshna and Humphrey.
However, given the New Zealand business dynamics and prevalence of SMEs, how many business owners go into business making such an assessment? And even if they do, how relevant is it, even in its application to public companies? Essentially Investment Methodologies make some assumptions:
- All investors are long term investors (MRP and Beta driven by long term averages) – but at the same time value liquidity over control.
- All investors hold fully diversified portfolios
- All investors are rational
- All investors accept the same level of risk
Even brokers make decisions on allocation of assets based on an individual’s risk profiles, and other emotive factors (perception and opinion on certain industries). We know that public markets have bull or bear phases at the extremes so are driven by sentiment and emotion. WACC and Other Investment Methodologies are not irrelevant, however sentiment and emotion are also as relevant.
Realistically a transaction will occur at the price someone is willing to pay. So really, value is determined by the price someone is willing to pay.
When performing valuations, we are really trying to find the point where value and price meet.
Would all buyers looking for that asset pay that same price? If valuation is about assessment of risk, this would mean that to pay the same price – everyone would have the same risk profile and appetite. This is clearly not true. How do we value sentiment and emotion?
The only way to truly incorporate the other drivers of value in New Zealand is to have access to comparative business transactions. Currently the only reference to private business sales available is Bizstats, which is a collection of statistics of businesses that have transacted through business brokers. Usually these are smaller end businesses which reflect ‘buying a job’. There are some larger businesses, usually those with less complexity or more common businesses in retail or professions. The issues could be that there are no relevant comparables, no relevant recent comparisons or not enough statistics to be able to objectively use the stats. Larger transaction practices may have a database; however, it is likely that there will be one of these will still be an issue. Many mid-market businesses ($5m to $50m) and even larger New Zealand businesses ($100m) are often trade sales, management buy outs or succession plan transactions. These statistics are either not captured or captured by disparate parties. Though there are International data aggregation tools, again which have some private company data from other countries, the application to the New Zealand market would be limited. This is a very significant shortcoming in the New Zealand business valuation environment, and one that would pay for valuation professionals to try and address collaboratively.
What am I trying to say? The New Zealand market is unique both in composition and value drivers.
There may be good market information to measure the small end of the SME market where there is market information captured. There is a dearth of comparable market transaction information for the mid-market and these businesses can be very challenging to value. Traditional investment methods of valuation may have some relevance, however, also have limitations which should be considered and adjusted regarding each transaction.
When obtaining a valuation for your business, your business valuer should understand your business extremely well. A good valuer will ask lots of questions, and a lot of it will not be about the numbers. They will seek to do this so they can find the most appropriate methodology and apply judgement if applying investment methodology. They will understand that technical formulas need to be balanced by commercial reality. They will have enough experience to understand whether the number that drops out makes sense and based on the questions they have asked they should be able to justify the value.