It could be the transfer of an owner-managed company to a listed corporation or a capital growth investment in an EIS-qualified company. Business valuations are essential to corporations’ financial transactions and are a crucial tool in making decisions for entrepreneurs. An understanding of the way companies are valued and what factors determine value can help entrepreneurs maximize the value of their businesses.
In reality, business valuations require expertise, technical know-how and a thorough financial analysis; however, the word “value” can differ for different people and is a subjective concept. Value is part of art and science, and it requires judgment and expertise. There are established values and guidelines for valuation. However, two appraisers presented with the same information could arrive at different conclusions.
The perspective on valuation can differ depending on your position and perspective – either a buyer or seller, an investor or investor or your need for risk and return. It is essential to understand valuation with a price. The value buyers and sellers might put on a business could differ; however, when there is overlap, the price at which the business can be purchased and sold will usually be agreed upon. In the event of a deal, an estimate of value should be completed before the event to assist the decision-making process. Still, ultimately markets are the ones that decide the value.
The best method to assess the value of business methods is available. However, the three most popular are: 1)) an income-based method or discounted cash flow (‘DCF’), 2) market-based approaches that use multiples from comparable transactions and listed companies or 3.) an asset-based method.
An income-based or DCF method forecasts the cash flow the business produces plus an estimated terminal value, which is then reduced at a suitable discount (usually called the weighted average of cost, also known as WACC) to calculate an estimated net present value for the company. The future free cash flows can be assessed both pre-and-post-synergies, although a buyer should seek to buy the business closer to its pre-synergy value as they take on the risk and often the cost of generating any synergies post-deal. Yet, DCF valuations are only feasible with a reasonable forecast of three to five years, and the process is subjective and dependent on the assumptions employed.
In actual practice, it’s generally more popular to use a market-based or multi-method method since they are straightforward to comprehend. Specific industry-specific multiples could be helpful, but generally, enterprise value (“EV”) multiples like EV/revenue or EV/EBITDA and EV/EBIT are popular. Revenue multiples are used for many early-stage, pre-profit or tech businesses such as software-as-a-service providers but for most profitable trading businesses. The most commonly used technique is EV/EBITDA. This technique assigns a multiple on an amount of (adjusted) earnings before interest, tax depreciation, and amortization of the company being evaluated. Since the earnings measure is derived from the top of the P&L, it is considered “cleaner” than EV/EBIT or price-earnings ratios since it removes the effect of financing arrangements that differ in taxes, tax rates, and amortization accounting rules that are in place between companies.
EBITDA will typically be adjusted for items such as one-off exceptional income or expenses, market rate remuneration for director-shareholders, discontinued operations, profit or loss on asset sales and shareholder or non-business-related expenditure. Recently, we’ve been making adjustments to reflect the impact of Covid along with, for certain companies, the extra expenses arising from Brexit.
Multiples are available through sources such as historical share transactions or funding rounds, proposals or other offers made to the company. However, the most important options are the multiples from comparable transactions between similar businesses and comparable listed companies that are discounting for differences in size and risk profile, reliance on key people and lower liquidity and marketability. In the real world, identifying a listed business or an actual similar transaction can take time and effort. Deciding on suitable discounts or adjustments is the point where experience is a crucial factor.
Equity valuation vs enterprise valuation
The distinction between the value of the enterprise (‘EV’) and equity value, as well as the bridge between them, is frequently misunderstood by business leaders who have yet to have the privilege of undergoing an investment in corporate finance. Enterprise value refers to the long-term debt of a company and equity funding, as well as the company’s worth to the capital providers. The valuation methods discussed earlier typically result in an estimate of the value of the enterprise, which is then converted to the equity value. Adjustments are made using the most recent balance sheet to determine the amount that must get paid to cover the value that the equity has in the marketplace (the value of equity).
Typically these debt-like instruments are subtracted from the equity value while any assets and cash are added. Other debt-like include pensions that are not fully funded, corporate tax liabilities and preference shares. The market convention generally assumes that any surplus or non-operating cash is utilized to pay off outstanding debt and therefore is included as the ‘net debt’ when the bridge is between equity value and enterprise value. It is also commonplace to presume that the company will have a “normalized” level of working capital upon completion, and that’s why adjustments are required in bridging equity value in the event there is a surplus or surplus in the working capital.
The definitions of things like debt, debt-like, cash, cash-like items net working capital, as well as the target for working capital are the subject of intense negotiation in the course of the deal process . These definitions affect equity value in a significant way because net-cash/net debt and the difference between the target for working capital and the actual working capital at the time of completion will be a PS in the form of a PS impact on the equity value. While some items are straightforward in their classification, others, such as deferred earnings or accrued management bonuses, are controversial and subject to discussion. The purchase price is often stated as being ‘debt-free as well as cash-free. The other price adjustments are laid within the SPA (Sale and Purchase Agreement) using completion accounts and true-up procedures. In reality, that means sellers must take care to pay off the debt and manage their working capital effectively before the sale. At the same time, buyers should ensure that their business will be equipped with enough working capital to run its operations once acquired.
Value drivers
There are many ways to improve its value to your company in the long run. However, it starts by understanding the value drivers specific to your company and your industry. A variety of value drivers are common such as growing earnings, revenues and cash flows, the quality of revenues (repeat and periodic) and the quality of earnings as well as a motivated and rewarded staff and management team, as well as competitive advantages and an undisputed position in the marketplace as well as synergies and scalability. Other elements that influence value are determined through the M&A process as a whole or by timing factors like the tension with buyers and the state of the economy or the activity of the M&A market.
Valuation is crucial when it comes to an acquisition, and a pre-deal appraisal of the valuation process is crucial. An advisor will provide an appraisal based on the most effective methods and their expertise and knowledge of valuation in relation to business finance and M&A markets.
If you’re considering selling your business, a trusted consultant in corporate finance can assist in preparing your business for sale to maximize the value of your business and help in identifying potential buyers who are most likely willing to pay a premium. From a buyer’s point of view, valuation should be kept under continuous scrutiny throughout the acquisition process and you should be ready to exit in the event the cost is too high.
