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 somebody is 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. The 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 someone requires for investing their money rather than spending it (which is equivalent to the rate of return they would get by putting their money into, say, government stocks), times 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 in Figure 4 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.

Under the discounted cashflow approach to valuation, the value of your business to an acquirer is the total of the future discounted net cashflows after tax. A simplistic example of a discounted cashflow covering three years is set out in Figure 5.

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.

The disadvantages of the discounted cashflow technique are:

• The appropriate discount rate for the valuation will be the purchaser’s weighted average cost of capital, or the discount rate the purchaser wishes to apply to a business with your risk profile. Obviously this figure will vary from purchaser to purchaser and therefore you will have to make an assumption as to what the purchaser’s appropriate discount rate will be to calculate a discounted value.
• 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 is a purchaser prepared to pay for the benefits in increased operational efficiencies, synergies etc that will come about from their purchase of the business? How far should these be stripped out of any projections?

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 the sale to the new party.
• 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 by the acquirer.
• 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 the sale.
• 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 it may appear complex, discounted cashflow forecasting approaches lend themselves well to spreadsheet applications and, once 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 be easily flexed to reflect changes in assumptions (so 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.

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	87.0	(5.0)	135.0
Discount rate compound 25.15%	1.1888	1.4132	1.680
Cashflow discounted to present value	73.2	(3.5)	80.4
Total present value	150.0
Price paid	(150.0)
Net present value	0.0

From the point of view of the finance director of a purchasing company, the decision whether they should buy or not in practice comes down to which is higher, WACC or the IRR as:

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

RETURN ON INVESTMENT

If the purchaser is looking to buy your business, they are presumably doing so on the assumption that it will make profits into the future which will provide them with a return on their investment. In addition to IRR above, this return can be expressed as a simple percentage such that if a purchaser buys your business for £1 million, and expects it to generate earnings (ie profits) of say £200,000 in the year after acquisition, as a crude measure, the return on their investment is £200,000 ÷ £1 million = 20%.

Obviously the above does not take into account the cash implications of the deal on their existing business (such as capital expenditure, movement in working capital etc), in the way that discounted cashflows and therefore IRR does. It is therefore a more crude measure. However, extending the principle gives other indicators which investors may use to consider the value of the business.

The second of these is payback period, which is again a crude way of measuring risk. In this case, assuming that earnings will continue to run at £200,000 per year, the payback period (ie the period it will take until the original investment has been paid back) is £1 million ÷ £200,000 or five years. Obviously the shorter the payback period, the quicker the purchaser will be ‘seeing their money back’.

The same formula (£1 million ÷ £200,000) also gives the P/E ratio referred to above.

SECTOR SPECIFIC

Many trades, particularly those where there are a relatively large number of small businesses with therefore a constant high number of such business sales during any one business year, tend to develop their own specific basis of valuation and normal deal structure.

For example, you will often see a professional firm, such as solicitors or accountants, sold on the basis of a multiple or gross recurring fees, while valuation of a hotel will be a function of room rate, occupancy rate, and number of rooms; restaurant valuations will be driven by numbers of covers; and pubs by barrelage.

Brokers in these areas of business will often express a valuation in terms of these key metrics. So, for example, brokers dealing with residential care homes will often express a value in terms of £X per bed, for comparison purposes.

As a result, fairly standard bases of sales valuation may grow up such as: ‘For business type X, the sale value is likely to be twice annual gross sales plus the stock, furniture and fittings at cost.’

In addition, there may also be fairly standard approaches to structuring a deal. This is particularly applicable to small service or professional businesses where the value of the business often lies in the personal contacts and network of the existing owner of the business. Any purchaser considering buying such a business has first of all to make an assessment as to whether there is a business once the principal has gone. Assuming that the purchaser believes they can manage the business once the principal has departed, they then have to consider to what extent the business’s earnings will be damaged by the departure of the principal and how they can best manage this to reduce the damage. In these circumstances, a payment spread out over a period of years based on expected earnings, with the existing owner staying on as either an employee or a consultant for a period of say, one, two, or even three years in order to ensure a smooth handover of the business and the contact base to the new owner, and with an escalator either increasing the price paid if performance exceeds expectations or reducing it if it falls away, is not unusual.

EARNINGS MULTIPLES

The most commonly used basis of valuation, particularly for manufacturing businesses is the multiple of earnings approach. This is calculated simply on the basis of earnings/profits (before interest and tax, known as EBIT or PBIT) times the appropriate multiple. The level of multiple to be applied is then obviously a matter of judgement, given the strength of the business and the current economic circumstances, but it would not be unreasonable to expect a multiple of say five to seven times current earnings, when looking to sell an established manufacturing business with a good market position, albeit subject to normal competitive pressures that requires involvement of a good management team.

The worse the competitive position or reliance on strong management, the lower the multiple that should be expected. The clearer the competitive advantage and steadiness of the earnings stream, the higher the multiple that would be sought.

WHAT PURCHASERS WILL AND WILL NOT PAY FOR

It is evident from the above that earnings, both current and future, are crucial to almost every business valuation whether in terms of profit or cash. So earnings, current and future, are the starting point for a purchaser and a seller to consider valuation. This therefore reinforces the point that the seller needs to be able to demonstrate the business’s real earnings potential, by pointing to demonstrable profits and earnings in the business. This means that the seller needs to be thinking ahead and ensuring that all earnings and profits are clearly and demonstrably flowing through the business’s books so as to be able to show these to a purchaser when the time comes.

If you have been diverting profit or business off into another vehicle, or into personal trading or doing work in the black economy, do not expect to be able to persuade the purchaser to rely on your word that such earnings exist and should be taken into account when they calculate how much they are prepared to pay for your business!

Furthermore, do not expect the purchaser to pay for the benefits they will bring to the business. If your business is turning over £1 million and making £100,000 profit, you may feel that once this has been acquired by Large Co, because of their extensive distribution network and manufacturing expertise they should be able to grow your business to sales of £3 million and profits of £450,000 within a couple of years. This may be completely correct, however, do not base your idea of the business’s value on a turnover of £3 million and profits of £450,000, because the purchaser will be taking the view that value will only arise as a result of the work they have to do on your business once they have acquired it, and they will not base their purchase valuation on this future worth following their input, but upon its current performance.

Finally, remember also that turnover as such does not have a value. Turnover is only a tool to generate profit and it is the profit that your business generates as a return on the investment in buying it that will have a value for a purchaser.

Do not expect purchasers to factor into their prospective offer prices any element of ‘compensation’ to you for either the emotional effects of giving up your business, or the costs and time you have put into building the business to where it is today. The brutal truth is that the purchaser is not interested in how much time or money you have spent on developing your business. They will be interested in how much money they can earn from running the business going forwards in respect of which your sunk costs are completely irrelevant.

SUMMARY

The business’s value is what somebody is prepared to pay for it; and what they are prepared to pay for generally is a future stream of profits and cash. The only question therefore is how much money are they prepared to pay for that future income given its apparent degree of risk or reliability?

In summary the basic methods of valuation and their pros and cons are as follows:

	Pro	Con
Asset value: the value of all the assets, less the value of liabilities on either a ‘book’ or a professionally valued basis	Going concern and forced sale values provide ‘cover’ against worst case	Book values are ‘meaningless’ and asset valuations do not reflect value of the trading business being bought
Market value: the going rates for your type of business	Easily understood comparison	Difficulty of getting the relevant reliable, comparable information
Discounted cashflow: the value of your future annual cashflows, discounted back to the present value in terms of cash today	Makes everything explicit and qualified	Finding the correct discount rate and the underlying uncertainty of future cashflows
Return on investment: the profit earned in future years expressed as a percentage of the investment required	Easy comparison between investment opportunities	Not cash based and dependent on projection of future earnings
Sector specific: standard basis used for your particular trade	Common basis for comparison	Do not reflect the individual circumstances of the business and its properties
Multiple of earnings: profits times a ‘multiple’	Subjective but readily understood	Not cash based and relies on a projection of future earnings