Business valuations can take many forms. Given how many different types of businesses exist, different business valuation methods and business valuation formulas are used on a breadth of different scenarios.
In this article, we will highlight the key valuation methods, the strengths and weaknesses of each, and when and why they are applicable.
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1. Multiples, or Comparables approach
This approach is by and large the most common approach to valuing businesses. This is mainly due to the fact that it is a straight-forward and easy to understand method. The valuation formula used is fairly basic once you have the right inputs. The multiples approach considers what similar businesses have sold for in the past.
A comparables or multiples approach draws on publicly (and privately) available data to assess the value of companies based on the multiple of their financial metrics, e.g. revenue, Earnings Before Interest and Tax (EBIT), Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA) and Net Profit Before Tax (NPBT). These form a high level view of value based on recent acquisitions and sales in the market.
The same way a potential home purchaser will check the average price in the suburb or street they want to buy in to make sure their price is comparable, a buyer will undertake a similar process to ensure they are not overpaying when purchasing a business. In Australia, this data can be difficult to obtain publicly. Advisors have an advantage because they will have access to various research tools and industry knowledge which will help in forming a view on business value.
However, a few things need to be taken into consideration when adopting this approach.
- Is the comparable company of the same size?
- Is the comparable company in the same market?
- Do they have the same customers or spread of contracts?
- Who were the purchasers?
- Were there other synergies which may have affected the final price paid for the comparable business?
Some well established and familiar methods for assessing business value are the following:
- Earnings Before Interest and Tax (EBIT)
- Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA)
- A large manufacturing business may be valued at 3 to 4 times EBITDA to account for variations in margins across the industry, and to remove any effects of plant and equipment depreciation on the underlying value of the business.
- Similarly, a consulting or contracting business may be valued at 1 to 2 times revenue due to the short-term nature of the contracts and the high reliance on staff which can decrease value to a buyer.
Comparables approach in sum
- Simple to calculate
- For many industries, multiples are readily available / easy to find
- Easy to apply
- Difficult to find multiples for some industries
- Need to adjust findings for any unique businesses or qualities of a business (which can be positive or negative adjustments)
- If used in isolation, it ignores other important considerations such as working capital when assessing value
2. Discount Cash Flow
A Discount Cash Flow valuation uses a forecast of future cash flows to estimate value today. For a business, this means forecasting what your future revenue and profit will be over the next 5-10 years to give a buyer a way to value your business today.
Unfortunately, the discount cash flow method is one of the most over-used and misunderstood business valuation methods. Since forecasting what will happen in the future is difficult to do, a buyer will focus more heavily on the short term forecasts rather than what is going to happen in 10 years' time.
In practice however, there are two main variables in a discount cash flow analysis which can hugely effect the outcome of a business valuation by upwards of 50 per cent:
A. Discount Factor
Put simply, a discount factor represents the amount of uncertainty a buyer has about receiving future cash flows. The higher the number, the less confident the buyer is of receiving future cash flows.
- For a mining project, which is considered high risk, the discount factor can be as high as 20 to 30 per cent.
- For a lower risk business like a major supermarket chain, the discount rate would be low, likely around 10 to 15 per cent.
B. Terminal Value
A discounted cash flow needs a terminal value, which is a value given to all cash flows received past a certain date, typically 10 or 20 years.
Alternatively, it is also common to see a residual value or sale value used, which would indicate that after a period of time, the business would be sold for a particular amount.
Both of these factors can lead to wide variations in the overall valuation; these variations need to be understood to be interpreted correctly. The other downside of using this method is that you need to be able to predict the cash flow over time - which for many businesses is extremely difficult to do beyond 12 to 24 months.
Discount Cash Flow in sum
- Comprehensive analysis tool
- Widely accepted and generally understood
- Forces valuer to consider a number of key input assumptions (discount rate, future cash flows, growth rates etc.)
- Heavy reliance on input variables and forecasts
- Can be easily manipulated
- Not well suited to hyper growth companies or industries
“Many of our clients come to us initially with a view of the value of their business, and through a process of education and guidance using the methods discussed here we are able to work with them to refine this view and reach a decision on a fair price. Having said that, we endeavour to strive for the highest price possible when selling a business, but it is good to know what the business is worth prior to going into a sale process as it is one less unknown to deal with.” – Sean O’Neill
3. Sum-of-the-parts, or asset based valuation
An asset-based valuation is a bottom-up approach to valuing a business. It takes the view that the total value is based on the sum of all the parts of the business, rather than looking only at cash flow or comparable sales. It focuses on the actual components of the business like equipment, plant, property, patents or IP and goodwill, basing the value on the sum of all of these parts.
This business valuation method is used for businesses which have component parts that do not lend themselves to a consolidated approach. Businesses that are are asset-heavy (such as asset hire companies - e.g. construction, vehicles, furniture) use this method as it's a straight forward approach and shows a purchaser what they are actually buying.
A sum-of-the-parts method is useful for businesses with distinct divisions that do not necessarily interact much with each other, or geographies that operate independently and under different market conditions.
This method leverages the others discussed in this article (multiples, comparables, and DCF) but rather than assessing on a consolidated entity, it then builds the value up from the composite parts to reach an overall value for the business. This is especially important when some divisions of the business are either not as profitable or are subject to different valuation multiples, and therefore need to be assessed independently.
Importantly for an asset-heavy business, a purchaser will come to a decision point of - 'Should I just buy the equipment or assets myself and set up the business, or buy the business and leverage their goodwill and existing business structure'. As such, it is important to keep this in mind when assessing businesses of this nature using an asset-based valuation.
Asset based valuation in sum
- Good method for businesses with multiple divisions or geographies
- Can be supported with evidence (asset valuations, purchase orders, depreciation schedules)
- Clearly sets out different components of value
- More complicated to calculate
- Presents buyers with a decision point of buy or build (this can be both a strength and a weakness)
- Requires an understanding of other methods of valuation as a basis for this method
Which business valuation method should you use?
While this list is not exhaustive, we've covered the most common valuation methods we come across when dealing with buyers and sellers in the market, both domestically and internationally.