Small Business Valuation
Determining the value of a business is a complex task. In fact, determining a value of anything is subjective, and just as G.M. Keynes said, it depends on how much is someone willing to pay to own it. This is pretty much common understanding of all societies and cultures that I know of. However, for our topic we are interested in business valuation, which in practice means an activity that will generate an income beyond the costs that it consumed during that process. Therefore, idea is to buy something cheaper that it will is expected to make in the times ahead. As with pretty much everything this is not as simple as it sounds. Because of its subjectivity the process is further complicated on the seller’s as well as on the buyer’s side. Despite all difficulties of subjectivity, a decision has to be made so that parties can move on to the next challenge. It is always advisable that to avoid any big mistake, services of professionals should be considered as along as they fall within the range of affordability. Also, it should be kept in mind that be it buying or selling, aside from all analysis and professional opinions there is the unavoidable part of negotiations with other parties. Therefore, with the subjectivity on one side and negotiations on the other, concept of ‘true value’ does not happen does not happen. What is left, is to try and be as close as possible which is achieved by gathering as much relevant data as possible. The more information which can be translated into numbers the better. To make the process even more difficult, subjectivity is the only qualitative factor in the process of valuation. This is one of the main reasons why businesses, and premium professional consultants, use more than one valuation method so that in the end come up with some sort of average value. Changing trends, economic conditions, demographic factors, are only a few obvious ones, it seems to me that more qualitative factors we consider the harder we make it for ourselves. This should not be understood as a recommendation for ignoring them, but rather a call for stricter concentration on the information that can be obtained and measured. Methods below are all based on calculation of numbers which in a way provides for a more exact answer. Let us not forget that actually a lot of information in the financial statements are also based on assumptions and estimates. In other words; there is subjectivity everywhere!
EBITDA Multiple
EBITDA stands for “Earnings Before Interest, Taxes, Depreciation and Amortization”. It is an important figure for a business since it represents income after core business activities, although in strict terms and for larger projects it requires further scrutinisation of inputs which generated the figure. If all things equal, EBITDA is a straight forward figure that it is shown on income statement. Valuation based on this method would mean that buyer and seller would agree on a multiple factor, let say five times EBITDA. It is as straightforward as it sounds, providing there is an agreement on the multiple factor to be used!
Despite being simple and clearly stated on the income statement, normally there would be few workings to have in mind. For example, is the business well established or at an early stage? In case of a long operating business there should be taken into consideration figures from previous years, let’s say for the last five years. However, figures from the last year are more important than those from five years ago. This common sense approach raises the need to give a different, more appropriate, weighting to each year’s figures.; the earliest the least, the latter’s the most! From this step on an average figure per year should be easily calculated.
Research shows that although simple and straightforward it is actually widely used among businesses in a variety of industries and size of the firm. Because of its reliance on financial statements, assuming that we are talking about a set of audited accounts from a credible firm, this method is very much applicable for businesses with a long track record and fairly established presence on the market.
Revenue Multiple
Just as the name suggests it uses revenue multiplied by the agreed factor. It is also advisable to take into consideration historical data and give an appropriate weighting using the same principle of the earlier and latter figures. It is very simple, although a scrutinisation of the revenue figure is necessary, and it is generally used to have a broad idea of business worth. It is typically used for early stage businesses which are eventually breaking even. It is worth noting that multiple factors are easily accessible for a large number of companies. It comes down to negotiations to determine what deviation from industry average will adopted.
Book Value Method
This method is the simplest of all methods mentioned here. It is not that often used any more as result of changes that has taken place in the production process. It is straight forward; book value of business equity on the balance and multiply it by a factor. Although this simple it is helpful in several approaches:
1. Engineering companies with large quantities of machinery and other physical assets
2. It is used by lenders who want security against loans provided
3. It can also serve as an investment target. Companies that the market has overlooked for a variety of reasons
4. There is a specific type of investors who look for companies with high net assets on the book but not attractive business operations. The asset striping is a term used for these cases of investors who buy companies to take them apart by selling valuable parts and/or assets of the business.
Discounted Cash Flow Method
Three methods mentioned so far are very commonly used and well known for the greater part of business community. An important factor for being so popular lies in their simplicity and reliance on traceable information, financial statements, which very often are also appropriately audited. In fact, EBITDA method remains most popular. Although very brief in description it was clearly mentioned that all of them required some sort of history, a track record of business operations. So then, what about the ones which just started, can they be valuated? Before answering the question lets just think about application of the methods above on new types of businesses that we witness every day. How can a business be valued which started few months ago? What about design firms, architecture studios, engineering and medical businesses, or technology start-ups, whose assets probably are made of a computer and a desk? Even equipment is hired or on a lease. Or what about a small firm whose owner cracked the idea and showed that it works in practice, it found the market, but it needs further capital injection to actually make profit? All these cases and many more similar may not have much from physical assets but they have people within them that represent value for the business. It is these businesses that are driving economies in the countries with very little physical assets, natural resources, and expectation is that that for a foreseeable future its role, knowledge economy, will outgrow all other sectors. Examples of such firms are everywhere around us.
The short answer to the question of valuation is; Yes, even this type of businesses can be valued with relatively high confidence! It is for cases like these that Discounted Cash Flow (DCF) method is considered the most appropriate. It is commonly used and second in popularity after EBITDA multiple method. In fact, they are usually used together to come up with a better estimation on the firm’s value. When the potential firm for acquisition is a start-up or lacking sufficient track record a projected EBITDA is used. However, the DCF method is likely to provide more reasonable answer. If anyone out there thought they will get away from estimation and subjectivity, this is bad news. The DCF method relies exclusively on projections of the firm’s activity; revenue, expenditure, profits and cash flow. For the purpose of valuation, the emphasis is on the Free Cash Flow (FCF).
During the process of negotiations there should be an agreement on projected figures, or for those wanting to know the value of their business they need to get these from a reliable source. Importance on getting projection correct can never be overestimated. Just think of the likes of Kodak, Nokia, Blackberry, Skype…list is almost endless. In case you got it wrong, you are not the only one! Even companies who could afford to hire the very best got it wrong!
No matter how small or simple business could be it cannot get away from two projections: future revenues and DCF factor. Typically, the real question is how to project revenues with so many factors affecting it? About complexity of DCF factor I am not going to go into. This article is too short and too broad. It should suffice to mention that there is a whole library of academic articles on the subject. If its set to high it causes for the opportunity to be missed. If it’s too low, it proves investment loss making in reality. Nevertheless, there must be assumptions and projections from it. These can dramatically alter the result and the value of a firm being considered. Not surprisingly, in reality it is difficult for a buyer and seller to agree on all assumptions.
Separate from all estimations, assumption, projections, and valuations the only true value is the one agreed upon the buyer and the seller. The more valuation methods are used the closer is to get to a number. The more numbers the better the estimate. In reality most business valuations prove themselves incorrect as result of many factors, some of them mentioned above.