DO YOU NEED TO KNOW ABOUT VALUATIONS?

You may well feel that business valuations are a technical matter which you would like your professional advisers to undertake so that you can rely on what they produce.

While I do not believe that you need to become a master of all the technicalities of valuations, I do think that as it’s your money that you will be paying to buy a business based on a valuation generated, you need to understand the basis on which they are put together. Each approach has its own strengths and weaknesses which you need to be aware of; familiarity with the techniques will help you deal with your professional advisers.

For those who would prefer to avoid the detail, however, a summary of the principal methods is set out at the end of this chapter.

RESTATEMENT OF EARNINGS

The first thing to appreciate is that most valuations are based on estimates of future earnings. It may come as a surprise in looking at these that both the sellers and your professional advisers will almost always make significant adjustments to both past and projected earnings information received from the target company. This is a normal part of the process and nothing to be concerned about.

Business owners, particularly in small or family owned companies, are not normally motivated to manage their company’s results to demonstrate high profits. Instead, they generally seek to manage their business and earnings in such a way as to minimise the tax payable, and it is fair to say that the degree to which business owners will ‘manage’ the figures to reduce the amount of tax they have to pay ranges from the completely legitimate, to the marginal, and right through to the completely illegitimate.

Grooming the business

If they have been well advised, the seller will have been working with their professional advisers, over a period of time leading up to putting the business on the market, on what is known as ‘grooming’ the business for sale.

In some ways the grooming process should help you as a buyer since the activities will include making sure that all the paperwork is in order so that the due diligence process encounters as few problems as possible. At the same time the seller will be looking to manage the business so that it shows as valuable a profile as possible when they come to sell.

In preparing figures for you to look at, they will also therefore be looking to adjust the results to show as high a level as possible of underlying sustainable profit, and hence to persuade you that you should pay a high price for the business.

The normal sorts of profit management that might be adjusted for include:

• salary for the owner set at a high level so as to soak up all available profits and avoid double taxation, or for family members working in the business (e.g. spouses)
• high levels of fringe benefits for family members, such as expensive cars
• above market rents charged to the company for use of property owned by the owner or their family personally.

In addition to the above, business owners may well also have been undertaking practices such as:

• paying salaries to family members who have absolutely nothing to do with working in the business
• charging personal expenditure such as pleasure trips to the business
• putting assets bought for personal use (such as a home computer) through the company, etc.

To obtain a realistic picture of the sustainable level of earnings of the business, the sellers’ advisers will therefore be looking to strip out all such elements and where appropriate, replace them with reasonable open market estimates of, for example, a director’s salary, as someone has to run the business, and market rent for the building.

Similarly, your advisers will be looking to ensure that all costs are taken into account on a realistic basis going forwards. So, for example, if the owners have not been charging the business for certain costs then these will need to be provided for in assessing likely profitability going forwards, as well as any financing costs that the business will need to bear as a result of the sale.

IN THE BLACK

And finally, in thinking about the quality of earnings when considering the business’s value, you should only pay for what you can see. Your valuation must therefore only include easily recognisable and traceable streams of income.

So what happens if the owner tells you that the business has significant earnings that are not going through the books? My view is that the discovery of this sort of issue should cause you to seriously think about walking away from the sale completely, because the obvious questions are:

• How can you audit and rely on these claimed receipts? After all, you certainly won’t be able to sue the seller later if it turns out not to be true.
• How do you know there aren’t matching liabilities that aren’t on the books?
• What else is not on the books?
• Do you really want to buy a business which might be subject to a significant tax investigation at some future point?
• What happens when you take over? If you keep income off the books you are laying yourself open to all sorts of tax problems. If you put it all through the books, sooner or later the tax authorities are going to notice the significant change, which may cause them to ask questions.

You should also remember that under current legislation, if your professional advisers become aware of any grounds for suspicion of any activity that comprises tax avoidance, they are now under a duty to report this to the National Criminal Intelligence Service or face criminal proceedings that can land them in jail. So if you know, the chances are your advisers will know, and if your advisers know, the police and tax authorities will do so very shortly afterwards.

Overriding all of this must of course be the thought what you really want in a business you are buying is certainty about what you are getting. And if you can’t trust the existing owner, then you shouldn’t be buying the business.

ASSET VALUATION

Since you are acquiring the assets of the business, the value of these is a logical place to start in valuing a business.

Indeed, for businesses that are loss making or that have failed, this is normally the fundamental basis on which a liquidator’s valuations are based, because if the company is loss making, it has no stream of profits to multiply or project in order to generate any of the other forms of valuation.

There are essentially three bases of valuation of assets that you may see referred to. These are book value, going concern and forced sale value.

Book value

Book value represents the total value of all the assets (net of the relevant liabilities) as stated in the company’s accounts. It is also referred to as net asset value or net worth.

However, you should never confuse these accounting ‘values’ with real values. Accounts are based on a convention of historical cost, which means that an asset is booked into the company’s accounts when it was bought. It will then have been subject to depreciation to write the cost of the asset off over its useful life. The net book value of that asset in the accounts is therefore its original cost less the depreciation charged against it over the years since it was bought. The resulting ‘book value’ may be accurate from an accounting point of view, but you cannot rely on it bearing any resemblance to the open market value of the asset involved.

For example, computers are generally depreciated over three years, but the second-hand value of computer equipment the day after its box has been opened may be a very small percentage of the cost of the new equipment the day before. Conversely, a property bought many years ago being slowly depreciated over say a 50 year useful life in the accounts, may have increased significantly in value. The real open market value of the computer will therefore be significantly less than the book value and the property significantly more.

Because the book value of assets in a balance sheet is based on their purchase price, there will also be some significant ‘assets’ of the company which may have no book value attributed to them at all. Do the target’s brands, patents, trademarks, designs, copyright, customer list, contracts, employees, have a value? You would probably assume that they do, but they will generally not appear on the balance sheet.

Some businesses require very few physical assets, the real value lying in the people, contacts and know-how. Obviously, in these types of businesses, the difference between the value of the business and the value of the net assets will be significant.

As a result of these problems with book valuation, businesses with reasonable performance will usually be expected to be sold for a value greatly in excess of the book value of the assets. The accounting term for the difference between the value of the assets and the value of the business is the goodwill of the business.

For these reasons, book values are hardly ever used for valuing a business.

Going concern value

This is a valuation of the assets of the business on the assumption that they are all to be sold together as a trading business. It therefore takes into account how much a buyer will be willing to pay for this collection of assets given the ability of the business to earn money. This is the type of valuation that, for example, a receiver will obtain from surveyors and valuers, for the assets of a business over which he has been appointed and which he hopes to sell as a going concern.

Forced sale (or ‘gone’) value

This is the type of valuation that a liquidator would obtain when looking to sell the assets of a business that has ceased trading. It represents a break-up valuation of the assets that might be expected in an auction on the basis that there is no value to be obtained by their synergy as a package of assets with which to conduct a trade.

Occasionally, where you are buying a distressed business from an owner who wishes to avoid the bad publicity of liquidation, you may be able to acquire the business for significantly less than even the forced sale value of the assets, as you are taking away the problem and/or liabilities as well. There have been some very high profile examples of this in the public arena over the last few years, including the reported sale of Barings bank to ING for £1 and that of Rover cars by BMW for £10 together with significant funding facilities.

Obviously a seller’s drop-dead price is unlikely ever to be significantly below the forced sale or break-up value of the assets unless the business has significant potential liabilities to take into account in this way.

Forced sale valuations are also important as in many cases they are the basis used by lenders to calculate the security value of assets against which they are prepared to lend. They are therefore vital in establishing the level of finance you’re likely to be able to raise.

The Royal Institute of Chartered Surveyors (RICS) publishes guidelines on preparation of valuations known as the ‘Red Book’.

MARKET VALUATION

Going back to the house buying analogy in the introduction, this approach is somewhat akin to valuing a house for sale. To find a reasonable estimate for a property’s value, all you normally have to do is look in the property pages of local newspapers and find houses in a similar area of the same size to work out the average price for a house with the same number of bedrooms. It is then a matter of making any adjustments needed for the decorative state, potential, land, or any other special features of the particular property in question.

Similarly, with many businesses, by looking at the trade press or by contacting professional valuers specialising in the industry, you should be able to identify a number of businesses that have sold and the prices achieved in the recent past to form a view on values.

Using price/earnings ratios

As discussed in the last chapter, you might also consider the value of publicly traded businesses in the industry as a guide, based on the ratio of their price (business value) to earnings (profits), or P/E ratio, as published in the Financial Times and other financial press. As already shown, however, there are many weaknesses with this approach. If you do wish to use it, additional points to be careful of include:

• The earnings figure on which any calculation should be based should be the sustainable earnings figure, that is to say one that has been adjusted to remove some of the items described, but also needs to reflect the realistic prospects of the business.
• Ensure that you are comparing like with like as you will find that most P/E multiples published will be based on earnings after tax. Applying an after tax P/E ratio to a pre-tax earnings figure will obviously give you an inflated valuation.
• Most publicly quoted companies will be of a scale significantly different to a private company and again the scale of operation and perceived reduction in risk means that an investor is likely to accept a higher P/E ratio in a publicly quoted company than in a private one.
• As has already been discussed, public companies are under pressure to manage their figures so as to show good earnings for their shareholders, whilst private companies are not motivated to maximise earnings on paper, as this tends to result in tax that owners would rather not pay. Therefore the underlying approach to accounting policies, gearing and tax management may differ significantly between a private company and a public company in an equivalent industry, leading to significantly different earnings figures.

There has been some research done into the relative P/E ratios achieved from the sale of public and private companies. This tends to show that private companies obtain a P/E ratio roughly 50%-60% of the equivalent public company P/E ratio.

High P/E ratios

When reviewing P/E ratios published in the financial press, you may well come across some that appear to be extremely high. You may, for example, wonder why anyone would buy a share with a P/E ratio of 75 or 100, when this indicates that they would have to hold the share, in effect, for 75 or 100 years to generate sufficient earnings to pay back the price of the share. The answer is that P/E ratios tend to be determined by the perceptions of a company’s growth prospects. Therefore, a publicly quoted company with a high P/E ratio is one which the market believes has high growth prospects, and investors are prepared to pay a high amount for shares now in the belief that the earnings will grow significantly in the near future so as to give a good return on their investment.

Given the numbers of assumptions that will have to be made in terms of determining an appropriate P/E multiple to use in coming up with a valuation, for the reasons given above, a P/E ratio approach to valuation is usually considered too subjective, particularly when compared with the discounted cashflow approach.

DISCOUNTED CASHFLOW

Discounted cashflow, also known as net present value, works on the following basis. Which would you prefer, £1 now or £1 in a year’s time?

If you are rational, you would prefer £1 now, because:

• not only is £1 in a year’s time by definition more uncertain than £1 now (I might not be around to offer it or have changed my mind), but
• £1 in a year’s time is actually worth less than £1 now because you could place the pound I give you now in a bank account and earn interest on it for a year. In fact, if you could obtain a 10% net rate of interest, then in theory £1 now is equivalent to a minimum of £1.10 in a year’s time. Similarly you can see that £1.10 in a year’s time, given that rate of available interest, is the equivalent discounted back to a present value of £1.

Discounted future cashflows are therefore used as a way of estimating what you would be prepared to pay now, for the future stream of cash that is going to be generated by having bought a particular asset, business or project. This discounting of anticipated future cashflows is the method used in most large corporate transactions for business valuations for the purposes of mergers, acquisitions and disposals. For the purpose of valuing businesses, a theory called the capital asset pricing model generates a discount rate based on:

• the ‘risk free’ rate of interest that you require for investing your money rather than spending it (which is equivalent to the rate of return you can earn by putting your money into, say, government stocks)
• multiplied by a risk factor for investing in a particular sector, known as beta, which is generated by looking at returns generated by quoted companies.

For smaller businesses it is more appropriate to use the weighted average cost of capital or WACC. A simple example of how this is calculated is shown below for a company that is funded by £50,000 worth of long-term loans and £100,000 worth of share capital, where loans have an interest rate of 10% per annum and the equity is rewarded by a dividend rate of 20% per annum.

	Capital	Cost as %	Cost of capital
	£000	%	£
Equity (share capital)	100	20	20
Debt (long term loans)	50	10	5
	_____
	150		25 = 16.66%
			weighted average cost of capital

Under the discounted cashflow approach to valuation, the value of the target business to you is the total of the future discounted net cashflows after tax. A simplistic example of a discounted cashflow covering three years is set out below.

	Year 1	Year 2	Year 3
Operating profit	100	120	140
	_____	_____	_____
Add back depreciation	10	20	20
‘Cash profit’ generated from trading	110	140	160
Movement in working capital	10	(5)	15
Capital expenditure	–	(100)	–
Tax payment	(33)	(40)	(40)
	_____	_____	_____
Net post-tax cashflow	87	(5)	135
Discount rate compound 10% pa	1.1%	1.21%	1.33%
Cashflow discounted to present values	79.1	(4.1)	101.5
	_____	_____	_____
Total present value	176.5 (150)
	_____
Price paid
Net present value	26.5
	_____
Notes:
No residual value after year 3
Discount from year 1

Thus the net cashflows generated by the prospect of £227 (£87+ £135 —£5) are equivalent to £176.5 now when discounted back to present values. Deducting the £150 that you have to pay to acquire these cashflows therefore gives a net present value of £26.5.

Disadvantages

The disadvantages of the discounted cashflow technique are:

• The appropriate discount rate for the valuation is either your weighted average cost of capital, or the rate you wish to apply to a business with your risk profile. Obviously this figure will vary from purchaser to purchaser and therefore competing buyers may have a different discount rate to you, which will affect the value they place on the business.
• For how many years going forward should you calculate a discounted value before inserting a residual value that represents the entire future value of the business from that point to infinity?
• To what extent are you prepared to pay for the benefits in increased operational efficiencies, synergies, etc., that will come about from your purchase of the business? How far should these be stripped out of any projections?

Advantages

Nevertheless there are many advantages to using a discounted cashflow approach in that it forces a rigorous and quantified examination of a variety of issues that will be relevant to the performance of the business going forwards, such as:

• Any expected movement in profitability (up or down), whether for reasons already inherent in the business or from factors that come into play as a result of your purchase.
• The profitability of individual areas of the business, which may vary significantly from business unit to business unit.
• Capital expenditure required to develop the business or the scope to realise capital repayments by way of future disposal of parts of the business.
• Any increases required in working capital to cope with growth and turnover, or any reduction of working capital that might be achieved by way of better financial management following completion.
• Any other synergies or changes arising from the acquisition such as changes in the accounting date which impact upon the due date for taxation payments.

Whilst they may appear complex, discounted cashflow forecasting approaches lend themselves to spreadsheet applications, and once these are set up, the key assumptions can be varied, and revised forecasts run off with ease.

It is, however, easy to become confused as to which forecast was based on which set of assumptions, so ensuring strict rules about ‘version control’ and fully annotating the assumptions that lie behind each alternative forecast are vital so as to minimise confusion.

Such models can also easily be flexed to reflect changes in assumptions (what if sales are 10% better than forecast, or 10% worse than forecast?) to see how these affect the outcome. This process is known as ‘sensitivity analysis’ as you are looking to see how sensitive the outcome is to changes in key assumptions. It is a vital tool in planning your financing and trading after completion.

Discounted cashflows are also used to calculate the internal rate of return (IRR) of the project. The IRR is the percentage discount rate at which the net present value of the interest is zero. For the case above it is 18.88%. This means that the project overall gives a return of 18.88% as shown below.

	Year 1	Year 2	Year 3
Net post-tax cashflow	87	(5.0)	135.0
Discount rate compound 25.15%	1.1888	1.4132	1.6800
Cashflow discounted to present value	73.2	(3.5)	80.4
	_____
Total present value	150
Price paid	(150)
	_____
Net present value	0
	_____

From your point of view, the decision whether you should buy or not in practice comes down to which is higher, the WACC or the IRR, as:

• if your weighted average cost of capital is 10%
• and the return on the investment (i.e. the IRR) of this purchase is 20%
• then it makes sense to employ your capital/borrow funds and pay out WACC of 10%, to invest and make 20%.