DO YOU NEED TO KNOW ABOUT VALUATIONS?

Most business valuations will need to be undertaken by the relevant professionals and you will therefore not need to be a master of all the technicalities of how to come up with valuations. For those who would prefer to avoid the detail, a summary of the principle methods is set out at the end of the chapter.

However, it is probably useful to have an understanding of how each valuation is arrived at, how they are used and their relative strengths and limitations so as to be able to deal properly with your professional advisors.

RESTATEMENT OF EARNINGS

As most valuations are based on estimated future earnings, one thing to appreciate (as covered in Chapter 5 on grooming for sale), is that the professional advisors will almost always make significant adjustments to either your past or projected future earning statements in coming to a valuation or preparing documents to show to prospective purchasers. This is a normal part of the process and will be accepted by experienced purchasers.

Business owners, particularly in small or family owned companies, are not normally motivated to manage their company’s results to demonstrate the highest possible levels of earnings. Instead, they are generally motivated 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.

An important part of the grooming process is often therefore to manage earnings for a period to demonstrate the true profitability of the business. If this means paying higher levels of tax than you have been used to, you should console yourself with the thought that since the sale price you will achieve will probably be based on a multiple of earnings, you should get this extra tax paid back many times over.

The normal sorts of ‘legitimate’ profit management that your advisors will be looking to adjust in order to show as high a level as possible of underlying sustainable profit for valuation purposes and persuade the purchaser that they should pay a high valuation for the business, include:

• salary for yourself as business 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 (eg your spouse)
• high levels of fringe benefit for family members, such as expensive cars
• above market rents charged to the company for use of property owned by you or your 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, all such elements will have to be stripped out and replaced where appropriate, 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.

ASSET VALUATION

Since the purchaser is acquiring the assets of the business, the value of the assets often seems a logical place to start when valuing a business.

Indeed, for businesses that are loss-making or that have failed, it is normally the fundamental basis on which 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. 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 your accounts at the time you bought it. You will then generally have applied a depreciation policy that writes off the cost of the asset over the specific period of its useful life. The net book value of that asset in your accounts is therefore its original cost less the depreciation you have charged against it over the years since you bought it. 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, however the second hand value of computer equipment the day after you have opened the box may be a very small percentage of the cost of the new equipment the day before. Conversely, a property you bought many years ago, and which you have been depreciating slowly over 50 years 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 your 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 your brands, patents, trademarks, designs, copyright, customer list, contracts, employees, have a value? You would probably assume that they do, but they will not generally have a book value in your 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 although the price obtained for the business as a multiple of the book value is sometimes used as a cross check against similar calculations for other businesses in the same industry that have been recently sold to ensure that the price obtained is in line with those businesses.

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 someone 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 for the assets of a business over which they have been appointed and which they hope to sell as a trading business or going concern.

The Royal Institute of Chartered Surveyors (RICS) sets out a standard for valuation known as estimated realisation price (ERP), also referred to as open market value or fair value, which is the price that might be expected to be achieved given a willing seller and a reasonable period within which to realise the property or other assets. This is the basis normally used for valuing property or plant and machinery, as part of a going concern valuation.

Forced sale value

Also known as a ‘gone’ valuation. 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 breakup valuation of the assets so that there is no value to be obtained by their synergy as a package of assets with which to conduct a trade.

Obviously, your drop-dead price should never generally be significantly below the forced sale or break-up value of the assets unless your business has significant potential liabilities to take into account.

As before, the RICS publishes guidelines on preparation of a valuation called estimated restricted realisation price (ERRP) which is the value that a surveyor would expect to be able to obtain for property or plant and machinery given a restricted period (say six months for property, three months for plant and machinery) within which to sell.

Since both ERP and ERRP are used by different lenders to calculate the security value of assets against which they are prepared to lend to you, it is vitally important to understand on what basis the property or goods have been valued.

The main classes of items in the balance sheet and the general approach to valuation by purchasers are summarised below:

Asset	Valuation
Property; plant and machinery; finished goods stock	Professional valuation by chartered surveyor
Debtors	Review by corporate finance or insolvency accountant
Raw materials and work in progress	Professional valuation by a quantity surveyor
Liabilities	Accountant’s review

MARKET VALUATION

This approach is somewhat akin to valuing a house for sale. To find a reasonable estimate for the value of your property, all you normally have to do is look in the property pages of local newspapers, find houses that are similar to yours, in a similar area, of similar size, work out the average price for a house with the same number of bedrooms, and then figure in an adjustment for the decorative state, potential, land, or any other special features your own property has.

Similarly, with many businesses, by looking at the trade press or by contacting professional valuers specialising in your type of business, you should be able to identify a number of businesses that have sold in your industry and the prices achieved in the recent past to allow you to judge the basis of valuation.

If you are an active member of a trade association you may actually be able to call and speak to a number of other business principals who have been involved in buying or selling businesses of your type and obtain information from them directly as to the basis of the valuation involved.

An alternative approach is to consider comparing your valuation to those of publicly traded businesses in your industry, on the basis of the ratio of their price (business value) to earnings (profits), or P/E ratio, as published in The Financial Times and other financial press. This approach should be treated with extra caution however as because these businesses are publicly traded, there is a ready market for their shares. People buying their shares in the public markets therefore have less risk because they know they are publicly traded and therefore if they decide that they no longer wish to hold the shares they are able to sell them. The shares therefore have ‘liquidity’. Because there is not a public market in your shares, your business is unlikely to attract the sort of price earning multiples that a similar public company would.

If you wish to use a P/E ratio to consider business values, 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 pretax 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.
• Given the scale of publicly quoted companies, and therefore the diversity of their operations, it may be extremely difficult to find a quoted company that is sufficiently focused to truly provide an equivalent to your business.
• 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, 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.

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 where the market believes that it has high growth prospects and that 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 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.