Even if you are not looking to sell part or all of your business, how many times did you wonder how much your business is really worth? What is the maximum price you would be willing to pay when negotiating the purchase of your business?
Unlike public listed firms, whose prices are constantly available at the click of a button, a private firm's value is dependant on various factors that are not easily quantifiable. A business is worth only as much as a buyer is ready to pay for it. For this reason, I will be looking at the value of a business from a buyer's perspective.
The first step is to look at a firm's assets and revenue streams. A buyer is not looking to buy real estate or machinery, he is looking to buy into a source of profits. The value of a business boils down to current and expected free cashflows. Free cashflows are the firm's earnings before interest, tax, depreciation, amortisation and other income or expenditure that would distort the real value of earning.
This figure is then increased by a multiple. The choice of this multiple is dependant on various factors, both market and firm specific. There are various other methodologies for valuing businesses, but this is the most commonly used and is suitable for all types of businesses that are not running on a constant negative free cashflow stream.
There is no universally agreed multiple for a particular sector or firm, and multiples vary widely between and within particular sectors, depending on a number of factors, but principally certainty and size of future cash flows of the business are the main drivers in deriving this factor. The multiple applied to a business will depend on a combination of factors, some of which are detailed here.
Quality of earnings
Sustainability of earnings: A potential buyer needs to look at whether the firm he is acquiring is already at the apex of its business cycle, or whether earnings will continue to grow. He would also need to look out for one-off events that may have distorted previous earnings. These non-recurring events should be eliminated in the analysis.
Dependency of the business on the current owner/manager: A business that evolves around the capabilities of the current owner/manager is less attractive for a potential buyer, as once the buyout is complete, earnings will inevitably dip.
Customer base: A firm that derives a large chunk of its earnings from a few large customers is less attractive to potential buyers, as the loss of one of these clients will lower current earnings significantly.
On the other hand, a large and varied client base ensures that earnings will not be notably impacted by the loss of a client. Also, the potential growth of customers' industries plays an important role in identifying potential earnings growth from current customers.
Quality of assets
A potential buyer should ensure the assets the firm owns are in good condition. Even though assets that soon need replacement should be heavily depreciated in the books, he should also look into the costs of replacing these assets. The likelihood of changes in technology should be looked into, thus evaluating the risk of these assets becoming obsolete. There is also potential for the assets to be undervalued, increasing the attractiveness of the potential deal.
Quality of intangibles
Competitive advantage: A well-established business, which has a prized name, patent, or location, would be more valuable than a younger business without any of these intangibles.
Barriers to entry: The time it would take to set up a similar business as well as the expenses and risks involved in bringing the business to the current stage of development would impact the value of the firm. If it takes a significant amount of time, money and risk to build an identical business, this would add value to the current business, and a buyer would be ready to pay more for this business than for one which is pretty straightforward to set up.
Potential for further growth: A buyer will pay more for good growth prospects than for a low or zero growth business. This is because from a high growth business buyers will be able to recoup the initial investment much faster than a no-growth business.
Working capital: A firm with minimum needs for working capital would require less capital to be tied up, implying a higher value for the buyer. High sustainable cashflows would ensure less reliance on debt to run the day-to-day operations of the firm, as well as curtailing bad debts. Businesses with a history of good cash, debtor and creditor management attract higher multiples than those with a poor track record.
Synergies: A poor current structure could actually increase the worth of a business. Buyers look for easy wins. If a buyer identifies areas where he can make large efficiency saving, he will be ready to pay more for the business.
Also, when buying a business to form part of a group, one could benefit from lower overall overheads or increased marketability of his current product range. This would be achieved by the merging of certain business functions, or the newly acquired business would complement the current marketing and sales structure of the firm.
Selling or buying a business is a big decision, so one must ensure this step is approached in a methodological manner, ensuring all relevant factors are considered in deriving the correct value. Knowing how much your business is worth is also fundamental in planning further growth of the business, enabling you to have a more specific idea of capital that can be raised through loans or issue of equity, to finance these growth plans.
This article is for information only and should not be used as advice. Seeking professional advice is highly recommended. Karl Schranz, ACCA, MA Financial Services (University of Malta), M.Sc Quantitative Finance and Risk Management (Università Bocconi, Milan), was employed with Victor Schranz & Associates between 1998 and 2004, being appointed audit manager in 2003. From 2005-2007 he worked with JP Morgan Chase (London) in Credit Hybrid Derivatives as an analyst. He returned to Malta in July this year and has since taken on the role of consultant with Victor Schranz & Associates, offering corporate valuations, feasibility studies as well as corporate risk management.