“Valuation is an art, not a science”, or so the saying goes. But as Nick Muir explains, business valuations are a bit of both. In this blog, Nick sets out some common approaches to business valuations and offers advice to anyone brave enough to enter Dragons’ Den.
Dragons’ Den is back on our screens on Sunday evenings. It’s obligatory in my household to watch it together as a family.
My family loves the way the dragons ridicule contestants on various grounds. One of the most common is valuation, usually because the dragons perceive the valuation to be excessive. The contestants rarely seem to have a sensible explanation for their business valuations.
Oh, how I wish the contestants would set out sensible valuations in support of their pitches. I’d love to see the smiles wiped off the dragon’s faces.
So, if you’re thinking of pitching your business idea to the dragons, here are a few pointers on how you might value your business.
Profit multiple valuation
Profit multiple valuation is the most commonly used way to value a business. It’s most useful when valuing trading businesses.
The valuer determines ‘maintainable earnings’. This is the level of profits that the business can generate in a normal year. The valuer may need to adjust for ‘one-off’ income and expenditure items which could distort the profitability of the business.
‘EBITDA’, (which stands for earnings before interest, tax, depreciation and amortisation), is the most common measure of earnings and profits. It’s considered to be a good approximation of cash generated from trading.
The valuer then multiplies maintainable earnings by an appropriate multiple to arrive at a business valuation.
Maintainable EBITDA earnings (per annum) (a) £1,000,000
EBITDA multiple (b) 5
Business valuation (a) x (b) = £5,000,000
A high-risk business will have a lower multiple and value. Conversely, a low-risk business will have a higher multiple and value.
Other factors that could influence the multiple include:
- Growth – Growing profits attract higher multiples
- Size – Larger businesses tend to have higher multiples
- Reliance on key individuals in the business – reliance tends to suppress multiples because it’s an additional risk factor to the buyer.
Assessing an appropriate multiple can involve hours of research. In practice EBITDA multiples for small and medium-sized businesses usually fall between 3 and 6.
Surplus cash and the value of any investment properties are normally added to the business valuation to arrive at a company valuation. Borrowings would usually be deducted.
As the name suggests, this approach is appropriate for valuing businesses holding assets on an investment basis (for example, quoted investments or investment properties).
This approach involves adjusting the company’s balance sheet to reflect the current market values of its investment assets.
A deduction is often made for any tax that would be payable if assets were sold at their current market values. A compromise is usually struck between the buyer and seller at a 50% provision for tax.
Discounted cash flow (‘DCF’)
DCF valuations are not for the faint-hearted and thankfully I rarely have to value businesses and companies on this basis.
DCF valuations work by estimating future net cash inflows and applying a discount rate to them. The discount rate is applied to reflect the ‘time value of money’, so that future net cash inflows are shown at ‘present value’.
This present value represents the business value.
Risk heavily influences discount factors. High-risk businesses have higher discount factors, resulting in lower business valuations.
As with profit multiples, assessing an appropriate discount factor can involve a lot of research. In practice, discount factors typically range from 10% to 25%.
A DCF approach works well for businesses that have predictable/annuity type income streams.
The DCF approach is also often used in start-up situations where it’s difficult to use the profit multiple approach because there are no historic profits (although forecasting future results for a start-up is also difficult).
Again, business value won’t necessarily be the same as company value and adjustments may need to be made for surplus assets and for bank debt and other borrowings.
Rule of thumb valuations
Certain industries seem to have developed industry norm valuations ie ‘rules of thumb’. For example, it seems to be commonly held that accountancy practices sell at one times annual fee income.
My view is that businesses sell based on their profits or on the quality of assets. Because of this, other valuations approaches are more robust.
However, rules of thumb can be useful as a ‘cross check’ against profit multiple or DCF valuations and shouldn’t be ruled out entirely.
Facing the dragons
Whether or not you plan to face the dragons, there is real benefit to be gained from sitting down and thinking ‘What is my business actually worth?’.
You’ll find out how your business sits in your personal wealth portfolio. You’ll also have a greater appreciation of how you could increase your business’s value.
Having your business valued is often the first step in formulating a growth strategy.
Contact Nick at firstname.lastname@example.org if you’d like to discuss the value of your business.
But if you are planning on facing the dragons, you’re on your own.