The purpose of Valuation is to enable your business to maximise its equity value, but very few businesses use Valuation in this way.
The key to building a valuable company is to understand two critical factors:
- Value Gap – the difference between what your business is worth now vs what it could potentially be worth by improving your operations, growth rates and systems.
- Post-acquisition economics – is the business an investable asset that can generate cash on cash returns each year – even if you are no longer heading up the business.
Ideally you want your business to be worth more to your acquirer then it is to you financially.
You achieve this by reverse engineering as much value into the business as possible.
It’s a shift in thinking and well worth exploring further…
Understand that value is not correlated to price
There is a famous quote by Warren Buffet that rings true.
"Price is what you pay, Value is what you get"
So forming a view on the business valuation for a sale or specific transaction is not clear cut.
Ultimately the value is in the eye of the beholder and the price paid for a business will always be different to how it’s valued.
That’s because value is subjective and not prescriptive enough.
What I see as ‘value’ in an asset is not the same as what you see.
A great example of this is buying a property.
The final price the seller pays differs greatly to the asking price or range provided by the agent.
The reason for the difference between the value of the property and the price paid…
- Competition for the property often drives the price higher
- The final purchaser pays what they can afford
The fact that the price was different to the value doesn’t make it wrong.
It’s knowing that each of us will form different views of what value actually is.
But here lies a big opportunity for owners…understanding the magic of intrinsic value.
Intrinsic value is a concept based on the theoretical ‘true worth’ of an asset. It uses a scientific approach by understanding a business’ ability to generate future cash flows.
This is ultimately what buyers pay to access. So why wouldn’t you figure out a way to showcase this about your business?
Valuation is about a method that points to an outcome
There are many Valuation methods I could cover but in this article we’ll stick to the two most relevant:
1. Intrinsic Value – measures the value of the business based on the cash flows it generates – both past and future. This is the truest form of Valuation but there are some challenges that come with it.
2. Capitalisation of Future Maintainable Earnings – this multiplies a business’ adjusted net profit before tax by a capitalisation rate – this is specific to each business at a certain point in time.
Let’s explore the merits and drawbacks of these Valuation methods together…
The benefits of using intrinsic value
Ask yourself this question – would you rather be paid $1,000,000 now or in one years time?
I can almost guarantee you would say you would like to be paid $1,000,000 today because you understand money has time value – it’s worth less in the future than it is today.
The two main variables in determining the value of the business in this method:
- The annual cash flow ($)
- The predictability or stability of that cash coming into the business and generating this into the future
Thinking about your business the way it is now. Does it generate enough free cash flow to actually pay out your profits via an annualised dividend?
If it’s not doing this at the moment – don’t attempt to sell your business. You will not be able to demonstrate to your buyer the cash flow returns they will get from taking ownership of your business.
Intrinsic value is a concept based on the theoretical ‘true worth’ of an asset. It uses a scientific approach by understanding a business’ ability to generate future cash flows.
Future cash flows are what your buyer is paying you for when they purchase your business.
The stronger and more stable your business’ cash flows the higher the value of your business will be.
The drawbacks and lessons of intrinsic value
Trying to predict the future is often labeled a fool’s errand. It’s extremely challenging to map demand, volumes and activity over an extended period because profits go up and down in seasons and markets change. This makes it difficult for anyone to calculate the future cash flows of your business with any degree of reliability.
But some industries and business models have cash flows which are more predictable than others.
Warren Buffet invests his money into very large established companies in very stable and boring industries. These businesses will look the same 10 years from now. – Coca Cola, Apple, Bank of America, Kraft Heinz.
These companies all sell different things but have ONE thing in common.
STABLE CASH FLOWS.
Contrast this to startups, whose cash flow profile is somewhat ambiguous, using this type of method to value a business makes little sense.
I see startups and early stage companies value their business using cash flow projections often.
They have no stable cash flow. No certainty or credible predictions to confirm what they are setting out to achieve will happen.
In fact it’s the complete opposite of how analysing a businesses intrinsic value is intended.
These sorts of business valuations should be done differently. Based on other more important metrics like market opportunity, team capability and traction.
Valuing a small business using this approach may not always make sense either. Many small and medium sized companies have business models that don’t generate regular cash flows.
And because the intrinsic value and the cash flows are so unpredictable there is a heavy discount applied to the business.
That is because there is more risk compared to larger companies where the customer base is mature and cash flows more stable.
The other critical issue is there is a dependence on the founder and key people in the business. If that key person were to leave the business – for whatever reason – the business value will be impacted greatly.
These factors really impact the risk of operating the business. If there is too much risk surrounding the business operations and cash flows – buyers simply move on.
Value creation opportunity using intrinsic value
Here is the opportunity for businesses who want to use intrinsic value as a Valuation method…
De-risking the business – improve the consistency of its cash flows – increases the Valuation.
So if you apply its principles and make your cash flow more predictable you remove the risks from the business. Making it easier and less stressful to operate. The bonus side effect – your Valuation will grow.
Let’s look at the next method…
Capitalisation of future maintainable earnings
If you hear finance experts talk about ‘earnings multiples’ this is what they’re on about.
The multiple of earnings approach is the most common method of valuing a business because the inputs can be determined and compared easily.
What are future maintainable earnings?
Future maintainable earnings or (FME) is jargon. What it means simply is the Profit of a business and how likely that Profit will be maintained into the future.
It is important to wrap your head around the sustainability of that Profit.
We learnt that predicting the future is challenging, so now we have to get creative.
We need to resort to assumptions about your business.
Typically, FME is calculated on the current year’s normalised EBITDA (Earnings before Interest, Tax, Depreciation and Amortisation).
When referring to ‘normalised’ we’re trying to gauge the true profitability of the business, adjusting for abnormalities. Your business will most likely have a number of abnormalities in the financials.
Let’s go through some…
Your expenses are not accurate
Chances are your accounting profit is a bit misleading. Your tax accountant has probably given you some waivers over the life of your business allowing you to deduct certain personal expenses in your business, like the family car, travel expenses, home office etc…
There are also the usual ‘tax adjustments’ that get processed through your accounts to smooth out your personal earnings from the business which is largely based on what tax brackets you want to fall into – rather than the business paying you a market-based salary for the roles and functions you perform.
So when doing a business Valuation – we make adjustments to your accounts to ‘normalise’ this stuff and bring things into line. The purpose of this is to remove any ‘one time’ or ‘abnormal’ revenue and expenses so that we can get to the business’ true profitability from its operations.
It’s important to know that these normalisation adjustments have a significant impact on the EBITDA and Profit a business is really making.
An example of EBITDA impact
| FY20 | ||
| Net Sales | 3,500,000 | 100% |
| Reported EBITDA | 840,000 | 24% |
| Normalised Adjustments | ||
| Adjustments for market value rent | (180,000) | -5.1% |
| Adjustments for market value Director salary | (180,000) | -5.1% |
| (360,000) | ||
| Adjusted EBITDA | 480,000 | 13.7% |
In the above example the EBITDA reported in the P&L was $840,000.
But there are some factors that skew the real performance of the business.
The first one being that the factory premises used by the business is owned by the founder – and rent is discounted to conserve more cash in the business. If the owner was to rent the same factory from someone else – they would have to pay market price. So in this case, a normalisation adjustment is made to reflect the true market rent for the business premises.
The second major adjustment is the compensation paid to the owner of the business. Instead of a market-based salary the owner is paid via dividends. This skews the profit number because the salary is not in the P&L. Further, if you were to replace the owner with a manager – they would need to be paid a market-based salary.
This salary would be be expensed and reduce the profit in the business.
After we factor in these two variables the true EBITDA of the business is actually $480,000, not $840,000 originally reported.
The 10% difference to profit has a direct impact on the Valuation of the business. In this example there is a $1.2 million difference to the business’ Valuation.
There is a lesson from this exercise that is better to learn sooner rather than later.
Most business financial statements are misleading – and shouldn’t be relied upon to make key decisions about the true financial performance of your business.
Now let’s explore the multiplier…
Capitalisation multiples
The Capitalisation Multiple can be a hotly contested number in a Valuation but it’s relatively simple to work out. It’s determined based on comparable businesses in the market and certain ‘rules of thumb’.
The CM is a number that’s used to convert the future profit and cash flows from an investment into one metric. It’s essentially the inverse of a return on investment calculation. For example if you pay a 5 multiple on the earnings of a business, you’re effectively expecting a 20% return on the money invested.
It will take you 5 years to recoup your initial investment.
Multiples vary by a number of factors but there are consistent themes on why some businesses achieve higher multiples than others…
- Business size
- Growth rate
- Profitability
- Risk profile
EBITDA multiples are the most common business valuation metric because it allows for comparison of alternative investments.
For public companies, you have access to comparable industry data. For private businesses this data is hard to attain. So in place of eligible comparative data from the market we rely on “Rules of Thumb’ to help us get to the multiple number.
Valuation rules of thumb
The majority of small businesses > $2 million in revenue are valued on a CM of 3x.
This assumes the risk rate is 33.33%
Using this valuation methodology, if your business has sustainable profitability of $500,000 and a capitalisation multiple of 3 – your business would be valued at $1.5 Million.
Now a capitalisation multiple of 3 doesn’t mean you will get your money back in 3 years. All it means is you should expect a return of around 33.33% per annum for the life that you own the business.
Is this high? Well if you compare this to other asset classes like shares or property they usually yield anywhere between 3% – 7% – you’ll start to understand why a buyer needs to see a bigger return from your business to account for all the risks they are taking with buying your business.
There are too many uncertainties in most SME businesses that span across many different industries.
While there may be a good chance your business can continue to achieve a profit of say $500,000 p.a.
There is also the strong possibility that it won’t.
Reversing the value from the buyer back to you
So how do you increase the value of your business and make it a more attractive investment for your buyer?
Looking back at the methods, we have identified four key levers to increase the value of your business:
- Increase the predictability of your cash flows
- Reduce owner reliance or key dependence on certain employees
- Increase sustainability of earnings
- Increase the business multiple by increasing the size and growth rate of the business
Getting clear on what the business is worth will allow to isolate these levers and pull them in the right direction before you decide to sell.
Putting the post-acquisition economics of the business front and centre.
You are able to demonstrate it’s true worth and the future value it will continue to build after you’re gone. Making it worth more to the buyer than it is to you financially.
Getting you the cheque size and terms you deserve.