I cut my teeth in corporate advisory doing company valuations. Valuations of companies of all industries, shapes and sizes.
The purpose of these formal valuations was to ‘tick a box’ due to one (or more) of the following events:
- A marriage breakdown – a business needs to be valued to calculate the division of assets.
- A shareholder dispute/exit – a similar reason to marriage breakdown above.
- A corporate restructure – a proactive tax advisor is implementing a corporate restructure for tax benefits.
Rarely did we undertake a formal valuation of a company due to a transaction or proposed acquisition.
I always challenged why we were hesitant to undertake such engagements. That was until I learned Warren Buffet’s famous idiom,
Price what you pay, Value is what it’s worth.
You see, when it came to forming a view of the valuation of a company for a transaction, we were always hesitant to assert a definitive value – because value is in the eye of the beholder.
‘Value’ is subjective
What I see as ‘value’ in an asset, is not the same as someone else. Let’s use a residential property as an example. The final price achieved by a seller often differs from the price indicated by an independent property valuer or even real-estate agent.
The reason for the difference is that the ‘Value’ will vary according to the individual purchaser and vendor. For example, in the case of purchasers, the price they are willing to pay is subject to their own personal circumstances – affordability, access to finance, their knowledge of the market. It often goes deeper than that – was the property presented well on the open day? Did it have a ‘homely’ feel? Was the real estate agent a douchebag? The price will vary due to a variety of circumstantial factors which are hard to quantify in a spreadsheet.
In addition, the fact that the price differed to an independent valuation does not imply it was wrong.
Different stakeholders form different views of what is ‘value’.
Herein lies the opportunity.
Warren Buffett is known for adopting the Benjamin Graham’s thesis of ‘Value Investing’’. That is, understanding the intrinsic value of a company, then buying it at a discount to its current price.
Intrinsic value is a concept based on the theoretical ‘true worth’ of an asset. It involves understanding the true value of an asset via a scientific approach, by understanding a company’s ability to generate future cash flows. In other words, this is the realm of valuing companies with spreadsheets and data, not ‘gut feel’ or ‘rules of thumb’.
Where share prices in public markets fluctuate irrationally due to news, company announcements, economic conditions, sometimes even the weather, the share price may drop below the intrinsic value asserted by value investors. Buying such companies at a ‘discount’ to their ‘true value’ results in a gain. Ie. I bought a valuable asset at a discount to its value – hence the term value investing.
There are 2 main techniques that financial analysts and accountants will determine the ‘value’ of a business. They are:
- Discounted Cash Flows (DCF)
- Comparable approach using a Capitalisation of Future Maintainable Earnings (FME)
Explaining Discounted Cash Flows
Ask yourself this question – would you rather be paid $100 now or $100 in 1 year?
I can almost guarantee you would take the money now. Because $100 in 1 year is not the same as $100 now. Cost of living goes up via inflation. There’s also a risk that I will neg on our deal in the future. Because of these factors, money in the future is worth less than it is today…e.g. $100 a year from now is only worth $95 in today’s terms.
Think about your business in the same way. Your business is an asset which should provide you with a cash flow stream in the future, via profits and dividends to you.
The value of your business is therefore calculated by discounting those future cash flows in today’s dollars.
The mathematical formula is:
The 2 main variables in determining the value of your asset is
1) The annual cashflow ($)
2) The predictability of your business’s ability to generate these future cashflows – represented by the risk rate r.
As you will see, there are a few practical limitations with this method…
Predictability of Cashflow
“Those who have knowledge, don’t predict. Those who predict, don’t have knowledge. “
Predicting the future cashflow of a business is challenging. Profits go up and down as markets shift. Technology and innovation change the way we do business. This uncertainty makes it difficult for anyone to calculate these future cash flows.
This is a reason why Warren Buffett’s portfolio of investments are comprised of large, established companies in stable ‘boring’ industries. Buffett invests in businesses which will very likely still look the same 10–20 years from now – think Coca Cola, Dairy Queen, Duracell. He tends to invest in industries which won’t see any change in for decades. He does this because cashflows are more predictable, essentially betting against change over the long-term. In other words, status quo is good because the status quo is predictable.
Contrast this to Startups that are trying to disrupt the status quo. Venture Capitalists bet on companies changing their industry over the long-term. Peter Thiel for example, invests in startups that strive to innovate and change an entire industry or create a new one. Think Facebook, SpaceX, AirBNB and Lyft.
The challenge is that it’s near impossible to value Startups on a DCF approach – because they have no cashflow! Furthermore, what they are trying to do is super risky and unpredictable. This is why valuations are based on other metrics like market opportunity, revenue growth and compelling stories…
Valuing small businesses on a DCF approach is also difficult as many small businesses don’t have regular cashflows. Most small businesses don’t last more than 5 years…
This is why the discount rate is a critical component to the DCF calculation.
Small businesses and Startups have a lot more risk compared to larger, established companies. They don’t have an established brand and market. They are more subject to economic and market fluctuations. Furthermore, these businesses are still dependent on the key person of the business – the founder. If that key person was hit by a bus, the business would cease to be a going concern. All of these factors (plus more) will impact the risk rate. In other words, the risk that the business will fail is higher for smaller, less predictable companies – resulting in a higher risk rate. The higher the risk rate, the less present value of cash flows. Conversely, a lower risk rate = higher valuation.
In summary, the DCF approach to valuing a business is the ‘truest’ form of valuation – however, it’s also the most challenging because it’s almost impossible to predict future cash flows.
Which brings us to our next approach of valuation – Capitalisation of Future Maintainable Earnings.
Capitalisation of Future Maintainable Earnings
When you hear accountants and talking heads on Bloomberg referring to ‘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 comparatively easily.
It is calculated as:
Defining Future Maintainable Earnings (FME)
FME is a jargon acronym used to define a company’s Profit that is likely to maintain into the future. Again, the aim is to understand the sustainable level profit that the business will generate in the future.
But predicting the future is hard!
So, we resort to assumptions.
Typically, FME is calculated on the current year’s normalised EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation). Sometimes it’s also normalised EBIT. It depends on the circumstances, business model and industry.
When I say ‘Normalised’, we’re trying to understand the true profit position of the company, adjusting for any abnormalities. Small businesses generally have a lot of ‘abnormalities’ in their financials. Let’s unpack this.
Your expenses are not ‘real’
If you’re business turnover less than $10m of annual revenue, chances are your ‘accounting profit’ is misleading. Your savvy tax accountant has probably given you advice to deduct some personal expenses in your business, like the family car, some home office expenses. She has probably recommended some ‘tax adjustments’ to your accounts so that your Director’s compensation is based on tax brackets, rather than market salaries.
When evaluating the financial health (and valuation) of a business, analysts will often make adjustments to the accounts to ‘normalise them’. The purpose of this is to remove the effects of unusual revenue and expenses to understand a company’s true profit from its normal operations.
Most small business accounts are prepared for tax purposes, not commercial purposes. These normalisation adjustments can have a significant impact on ‘profit’.
Let’s take an example.
In the above example, the EBITDA reported in the profit and loss was $510,000.
But there are a couple of facts that skew the true performance of the business. The first is that the office used for the business is also owned by the owner – and the rent is at a discount (not at arms length). If the owner was to rent this office to an unrelated party, they would want a market price! So, in this case, a ‘normalisation’ adjustment is made to reflect the market rent.
The second is the current salary of the owner. The owner is paying herself a minimal salary because her compensation is paid via dividends. The problem here is that the profit is skewed because her market salary is not reflected as an expense. If she was to replace her role in the business with a new employee, she would need to pay a market salary which would reduce the reported profit.
After normalising this profit for market value rent and salary, the true EBITDA value is $250,000. This 10% difference to ‘profit’ made a $1M difference to the company valuation.
This is an example of why financial statements for small businesses are often misleading.
They’re not a true reflection of the business performance.
Ok, so once the FME is determined, the next part is to decide our Capitalisation Multiple.
The Capitalisation Multiple is most often determined based on comparable transactions in the market and ‘rules of thumb’.
The Capitalisation Multiple is a number that’s used to convert the future cash flows and income expected from an investment into a metric. In other words, it’s a simplified version of the Discounted Cashflow method. One might even consider it a valuation heuristic.
The most common formula used for deciding the capitalisation multiple is 1/r or r^(-1). Similarly to the DCF method, r is the expected rate of return that an investor hopes to get by investing in a business. Using this capitalisation multiple, it is now easier to calculate the value of a business.
For large public companies, assessing comparable industry data is relatively simple as this information is publicly available. For private businesses, it is hard to attain data on comparable multiples. So instead, analysts will rely on ‘Rules of Thumb’ to determine the multiple.
Valuation Rules of Thumb
The majority of small businesses are valued on a capitalisation multiple of 3x FME. Why?
Well, because it assumes the risk rate (r) is 33.3%. Let’s use this example to demonstrate my point.
Let’s assume a small business has annual cash flows of $100k per annum.
Using the Future Maintainable Earnings methodology, a business with an expected future return of $100,000 and a capitalisation factor of 3 (reflecting the risk that a return of $100,000 may not be achieved) would be valued at $300,000.
A capitalisation factor of 3 equals a discount rate of 33.3% (1/3).
Using the discounted cash flow model, the present value of the $100,000 per annum in perpetuity would be $300,000.
Do you get my point? They’re one and the same.
Now, it’s important to note that a capitalisation factor of 3 does not mean that you will get your money back in three years. It means that you should expect a return of 33% per annum for the entire life that you hold that asset. Is this high? Well, compare this to asset classes like shares and property that yield anywhere between 3% – 8% and you’ll understand why an investor needs 33% return to factor the risk of investing in a small business.
There are a lot of unknowns and risk with investing in small businesses, hence why the required return must be higher. There is a good chance you may not get $100,000 every year for the life of the asset. There is also the possibility that you will lose your investment altogether!
Other ‘Rules of Thumb’
There are other ‘rules of thumb’ valuation methods used for specific industries and business models. For instance, certain types of retail businesses may be valued on the basis of a multiple of gross sales plus stock. Some professional services businesses have historically been valued on a percentage of revenue. These rules of thumb methods have emerged as a result of empirical market transactions. Accordingly, these may help you with a very high-level proxy for value – but don’t rely on them!
Remember, value is in the eye of the beholder.
Rules of Thumb (source: The Valuation of Businesses. Shares and other Equity, Lonergan)
Treating your own business as an investment
Now, for the fun part. How do you increase the value your business to and make it a more attractive investment?
Looking back at the valuation methods, the 2 primary levers here are:
- Increasing Cash flow and FME (profit)
- Decreasing business and strategic risk (R) by building more predictability in that profit and cashflow
I’ll unpack these levers in my next blog of this series – How much is my Business Worth? (Part 2)