Let us go back to basics.
- How do we value businesses?
- What has happened to the correlation between value and price?
What is my value?
Fundamentally the value of every asset is the present value of its future cash flows. The key variables to derive value are:
- Earnings – Determined by analysing historic performance trends and prospects to arrive at an income stream, or a future maintainable earnings figure.
- Discount Rate or Sales Multiple
For earnings with a finite life, the discount rate is applied to the series of earnings over time. If earnings have an infinite life and/or are difficult to forecast over the long term, the discount rate is a multiple (capitalisation) of a constant earnings estimate.
If the resulting value is greater than the core net assets required for operation of the business, this additional value is goodwill. Core net assets include inventory, debtors, fixed assets required for running the business, net of the trade cycle creditors. Goodwill reflects value in the business not reflected in your balance sheet and consists of intangible items such as reputation, track record, intellectual property, brand value, client lists, etc.
If the core net assets exceed the value of the business, the value of the business would be the cash proceeds from selling the assets after considering the costs of selling the assets (i.e. discounts, commissions). This is called the notional liquidation value.
What is my price?
In a market with active buyers and sellers, value and price are closely related. The only divergence is the motivation of the buyer.
A significant motivator in small enterprise sales is self-employment and control. In these businesses, often the wages paid to the buyer are included in the income to reflect the ‘buying a job’ nature of these businesses. The method of valuing small businesses typically uses Earnings Before Interest, Tax, Depreciation and Proprietor remuneration. There is historic private business sale data available, that includes the multiple of the earnings these businesses sold for.
With businesses of this size, some analysis and judgement often need to be applied because the business you are looking at isn’t identical to the businesses in the comparative data. Medium to large businesses are valued in a different way, using the discount rate method described earlier.
Discount rates are made up of an estimate of the cost of equity, plus the cost of debt (if applicable) in their respective proportions. The cost of debt is straight forward as it is based on current debt rates.
The cost of equity is usually arrived at by using the Capital Asset Pricing Model (CAPM), which estimates a required rate of return using an analysis of the following:
- Risk free rate of return: Normally long-term treasury bonds are usually used. This has trended down since the GFC. The long run pre-tax risk-free rate is around 4%. The current rate is closer to 1.5%. The selection of the long-run rate or current rate can have an effect on valuation and can widen the difference between valuation and price.
- Market Risk Premium: Equity investments carry more risk therefore require a higher return. This is estimated by a long run equity return from the listed equity market as a whole and assumes market average equity risk. This is around 8% net of tax for New Zealand listed companies.
- Beta: Technically, the equity beta is a multiplier on the market premium and is a measure of the volatility of a specific company in comparison with the market as a whole. Beta estimates of listed companies are derived from a long run observation of usually 3-5 years. A beta of 3 means your company is 3 times much riskier than the market. A beta of .5 means the company is less risky than the market. Stocks that are more volatile than the market have a higher required cost of capital because they’re higher risk. You then have the opposite for low volatility, low beta stocks. They are lower risk and have a lower required return on capital. Beta is not observable for private companies, therefore often public company Betas are used as an estimate, although then you need to apply judgement – no public company is going to be the same as the small business you are valuing.
Here is an example of discount rate build up and its effect on valuation.
- Risk free rate: 4%
- Post Tax equity premium: 8%
- Beta: 1
- 4% + 8% = 16%.
- If your business earnings is $160,000, your business value is $160,000/16% = $1m.
Liquidity and scale
Listed companies have liquidity and scale, private companies have less. The discount for this can be up to 45% and is usually at least 33%. The private company value in the example above would be adjusted to a low of $600,000 to a high of $800,000.
Value and Price divergence pre-Covid
In New Zealand, all but the top 50 listed companies are relatively illiquid. Pre Covid, some private businesses transacted at multiples of 6 or 7, whereas small listed companies traded at multiples of 4 or 5. So often there was no evidence of a liquidity discount in small private business. This does not correlate with the valuation methodology above, and in reality, the concept of value to an owner, or control was commanding a premium greater than the scale or liquidity discount.
Pre Covid, a premium was evident in large (over $50m revenue) private companies. This was generally driven by the competition between trade sale buyers and private equity managers funded by wealthy family offices. In essence the former was paying a premium for perceived amalgamation benefits to the purchaser and the private equity firms were paying a premium for control.
The mid-size private companies’ transactions not exposed to a trade sale buyer were generally consistent with the valuation methodology above.
Valuation methodologies are generally based on long run data and the assumption your cashflow will continue forever. The achievable price for your cash flow is now going to vary widely from theoretical value. Understanding why is the best way to transition your business to prosper post-Covid.
Things you cannot control…
In times of extreme uncertainty, cash is king. An increasing divergence between the NZX 50 and the rest of the market is already evident, mostly due to liquidity. The liquidity discount will be applied to at least the long run average of 33% and possibly up to 50%. Control premiums are likely to be less important. In the example above – the business that might have transacted at $1m pre Covid will have halved purely due to a higher liquidity discount.
While taxes are generally not accounted for in the CAPM formula, a future increase in tax will affect real returns to investors and should be considered when determining a risk free rate and market risk premium, particularly when the market returns are tax free like in New Zealand. For example, if tax rates increase from 33% to 50% top marginal rate, the discount rate increases from 16% to 20% which would reduce your $1m business by $200k and now the sale price would be $400k. Even a prospect of tax increases is likely to have this effect due to perceived effect.
Covid has impacted certain industries more than others. Some positively, others negatively (i.e. technology vs hospitality). Short term departures from the ‘normal’ behaviour in stocks is likely to impact beta and their perceived risk, and likewise their actual risk right now may be much higher than a beta implies, so this formula must be used with caution,
Now stuff you can control…
Demonstrating the ability to adapt and remain profitable will derive higher prices. Businesses with management resilience and visionary leadership will have a higher value which is more likely to be reflected in price.
This takes development of behaviours driven by a sense of purpose, and can take practice, but eventually become instinctive.
The quality of your income can be best demonstrated by establishing clear product market fit, post-Covid. Likewise, developing different marketing, distribution or trading channels, pivoting product features, and demonstrating over the next 6 to 12 months that your income and margins are maintainable can help improve value.
Demonstrating the above is likely to command prices consistent with value by avoiding additional risk factors applied by buyers for company specific risk. If value is derived by observing a comparable listed company, demonstrating resilience would justify using a lower company specific beta, or a lower range within industry beta.
Further if the management capability mimics listed company corporate governance, private company and liquidity discounts are likely to remain at the lower end of the range also. Trade sales where there is buyer motivation, the price commanded could be higher than valuation theory dictates.
Not all businesses sell in the same market.
We may observe transactions involving smaller businesses (the buying-a-job level businesses) to hold or increase. This would result in prices falling by less than larger businesses. However, these transactions are dependent on business lending liquidity for funding which may be scarce in the short term.
Large businesses and trade sales may stall. Trade buyers will be conservative undertaking the risk of integration on a fully priced basis. There may also eventually be the ability to roll up distressed businesses at lower prices where the risk/benefit equation starts to make sense. Family office funds may start chasing these larger businesses in the hunt for yield. These larger scale businesses which survive are likely to hold their value.
Medium sized businesses are the most vulnerable sector, where liquidity discounts will be the greatest, along with greater risk driven by uncertainty. These businesses should actively be developing survive and thrive strategies. Obtaining a valuation would provide a useful baseline, and also provide insight on the drivers of value. This can be useful for developing strategy to maintain or improve business value over time.
The old saying that accountants know the price of everything and the value of nothing is now reversed, they know the value of stuff but have no idea on price.
Why would you use the GS team to help you with both a business valuation and planning the steps to improve your business?
- Bruce Sheppard has co-founded several businesses, has sold a number of these, but also continues to own and govern quite a number.
- Our team includes people versed is statistics, data analytics, management, leadership, marketing, history, economics and financial analysis.
- We routinely deal with private equity and trade sale transactions.
- We routinely complete and manage both sale side and buy side due diligences
But more importantly when businesses sell, they tend to sell very close to our valuations, because we always ask ourselves these questions in role play:
- If I owned this business would I sell it for this price, and if not, why not, and if so, why?
- Would I buy this business at this price and if so why?
If you’re looking at selling (or buying) a business and have no idea what the value is anymore, get in touch below.