13/12/2011 Leave a comment
So last week we looked at the first 2 steps of business valuation, namely what are you valuing and why. We’re going to continue this week by looking at the next two valuation fundamentals, when to value your business and how to value your business.
So let’s get straight into it:
When to value your business?
Seems like a pretty straightforward question, doesn’t it? Well it is pretty straightforward but at the same time, very important.
The purpose of the valuation will determine when the valuation should be conducted.
For example, in a family law matter, the date of valuation should be the point at which the divorce is finalised by the judge. In terms of a valuation for accounting purposes (for example, an impairment review) this would have to be at the financial year end of the company or business being valued.
I would suggest you seek professional advice on this simple but important matter.
How to value your business?
Well, I could talk all day about this but for now let’s keep it simple. When valuing a business we normally use one of three methods, namely:
- Earnings based approach
- Discounted cash flow
- Asset based approach
There are various nuances relating to each of these methods but let’s look at each one in turn.
Earnings based approach
An earnings based approach, as the name suggests, takes the earnings of the business and multiplies this by an earnings multiple to calculate your business value. It’s an ideal method for a mature business with a track record of historic profits. Again, it seems pretty straight forward until you ask yourself the following questions:
- Which earnings do I use (Earnings Before Interest & Tax, Earnings Before Interest, Tax, Depreciation & Amortisation, Profit Before Tax or Profit After Tax)?
- Do I use historic or forecast earnings?
- Are my earnings sustainable or do they include a number of one off items of income or expenditure?
- Which multiple should I use and how do I determine it?
- Where do I get earnings multiples from and do I need to make any adjustments to these multiples?
As you can see when you start asking these questions the complexity starts to emerge.
Discounted cash flow (DCF)
DCF valuations are probably the most scientifically sound but still have their problems. The DCF method takes your future cash flows and discounts it back to present value.
The simplest way to think about present value is to ask yourself the question, would you prefer $1 now or $1 in a year’s time? Hopefully you would like the $1 now because it’s worth more than the $1 in a year’s time. The reason for this is because you could invest that $1 in an investment account and earn interest so that by the end of 1 year it could be worth $1.03 for example. The longer you go out the less that money is worth in today’s value.
A DCF takes all of your anticipated future cash flows and discounts them back on a similar basis to present value. The problem is of course that the result of the DCF valuation will depend on the inputs into the valuation, namely your future cash flow forecasts, i.e. RUBBISH IN, RUBBISH OUT.
The other problem with a DCF valuation is that it is recognised that in theory cash flows run in perpetuity (i.e. forever) and so even though your cash flow forecast will stop after 3 or 5 years the valuer may still take a view on cash flows after that. This value in perpetuity can account for a large portion of the overall valuation result even though there is nothing to substantiate it and hence this causes a lot of debate.
Asset based approach
An asset based approach is ideal where the item being valued has a market value that is easy to determine. For example, when valuing an investment property, you could either use an earnings basis and take the net rental divided by the market yield to determine a market value or you could just look at the value that similar properties have sold for in the area to determine the market value.
The same would apply for other assets such as motor vehicles, trucks, commercial property etc.
Valuations can be a complex issue and although we believe in keeping things simple we would caution against taking the easy way out when it comes to business or company valuations. You can easily miss the boat completely.
The best thing to do when encountered with a business valuation is to seek professional advice from people who value businesses for a living. Do your research and look for those valuers who are able to add substance and rigour to a valuation process so that the valuation itself can stand up to scrutiny for other parties.
Contact Lattice Capital on email@example.com for more advice on valuing your business.