What Does Business Value Refer To?
The value of a business has traditionally been considered to be represented by the sum of the assets or physical resources owned or controlled by the business. Analysts, shareholders and
business owners obtain and use the financial reports provided by a business to determine with relative confidence what the value of those assets are. Another way of contemplating how to arrive at the “value” of a business is to refer to the monetary sum a willing buyer is prepared to pay; and a willing vendor is willing to take for that business. In this context, value of the business is certain and agreed to.
However, why do we confront this transparently simple question of “business value” with expensive and time-consuming analysis? Why the requirement for licensed experts with their
complex legal disclaimers? And why is such a significant amount of research and due diligence needed to determine what a business is worth?
In fact by the late 1800’s all the tools used today in the fields of cost accounting and management accounting had been invented.
Value was measured in terms of property owned by the business, (Assets less liabilities). Arriving at business value was as simple and straightforward as establishing the value of net
assets in the Balance Sheet of the business. (Also referred to as the owners’ equity)
The 1960’s signaled the transition from the industrial to the intellectual economy. Intellectual refers to activities relating to knowledge, creativity, and collaboration of the workforce that
leverage diverse operating systems derived from IP – Intellectual Property, (not ownership per se of the assets of the organisation).
A very good indicator of this transition from Industrial to Intellectual economies is that the output of the mind occupies the functionality of the majority of workers today. Nearly eight out of ten workers now produce services – rather than “things.” Even products (tangible goods) are primarily purchased on the basis of intangible explanations such as brand, reputation, service levels etc.
In 2005, Stern School of Business (NYU) completed a study that had investigated 3500 companies (This is not a small sample size) The study set out to measure the correlation
between book value or equity and “capitalisation” over time. (Note: Capitalisation used here refers to the market value of shares.) So, the study compared value of net assets shown in
the balance sheet and share price at discrete points in time – over many years.
The study established its baseline at around 1978. In that period there existed a 95% correlation between the balance sheet and capitalisation. There was a very close relationship between the balance sheet value and the share value. Hence movement in the price of a share in a company was closely aligned and caused by movement in the balance sheet.
However, by 2005, the correlation had fallen to 28% for the same group of companies. Explained another way; 28% of the companies perceived value was explained by the physical net assets, but a whopping 72% of the “things” that created value in these companies were unexplained, not identified via the books, intangible.
In the present day, our accounting measurements such as ROCE [Return on Capital Employed], COGS [Cost of Goods Sold] and other familiar metrics explain much less in the intellectual economy than they did when they were invented for the Industrial economies of the 1800’s.
Consequently, it is not surprising that conventional endeavours to uncover “value” are only attempts to make “tangible” what is “intangible”, because increasingly and ultimately the pure financial accounting methods of arriving at the value of a business are virtually meaningless.
Why Perform A Business Value Exercise?
Having stated that financial metrics are less than effective in determining value, why then provide an explanation of how to use them?
When we view the statistics freely available in respect of company buyouts, and transfers it is not surprising that we find 80% of mergers and acquisitions do not add value. In fact 50%
of them actually destroy value. (Big bucks for consultants – less than impressive returns for shareholders).
This is one reason that buyers embark upon complex business valuation exercises – numbers are the only tool we have.
There will always be a role for establishing what a fair value is, due to the constant flow of businesses changing hands; someone has to guide the decision “What is a fair price!”
The fact is, estimating your business value is necessary for a few more reasons.
Is a particular business more or less valuable than its competitor in another suburb? Can we learn the secrets of a competitor – how did they make their business valuable?
The Trend Is My Friend.
In establishing value, it is important to compare the results you have with some form of benchmark. This is why we have “rules of thumb” such as “times earnings” mentioned later in this essay.
If there is one thing we have learned, it is that we must be optimistic about the future, however the past is (unfortunately or fortunately) a fair barometer of the future in most business cases.
The price that similar businesses have sold for, or a similar business is worth, may not provide any sound or meaningful support for you, but it remains for you to establish and substantiate
a differing opinion; and trends (measurement over time, or measurement across businesses or industries) should form part of the ammunition used.
Valuation Based on The Physical Assets of The Business.
Valuation based on the ASSETS of the company is relatively straightforward. This method is the “tried and true” method. As discussed in a previous section, this method is objective, proven and certain. However as also demonstrated, it is prone to significant understatement. As intangible assets become the dominant driver of value inside any business, the valuation method based solely on assets will be less likely to be relied upon by buyers and sellers. So why do Banks still use this method? Security! Banks are very risk averse and they can seldom sell an intangible if called upon to do so as a result of business closure.
Book value represents the application of traditional accounting concepts. The term refers to the purchase or acquisition cost of an asset less any accumulated depreciation for that asset. However when attempting to determine business value; “Book Value” is expanded to include all assets, less their accumulated depreciation and also less any liabilities. The short hand version is as follows: Assets less Liabilities equals Owners Equity [A – L = OE]. This is also referred to as simply “Equity”.
Benefits of Using Book Value or Equity.
Where this knowledge is useful
Analysts refer to equity when forming comparative views using ratio analysis for investing and financing decisions inside of a business. Examples are financial and value ratios.
Adjusted Book Value.
There are many valid reasons to argue that book value does not reflect actual or even the realisable value of the assets in question, and consequently the book value should be “adjusted” up or down.
For example property (generally but not exclusively) appreciates in value over time. As a consequence, making allowance for the changes in value (increases and decreases) can be
justified in certain circumstances.
Another way of “adjusting” the book value of assets is to try and reflect the value of “intangibles” such as goodwill, value of the company brand or patents and copyrights. In fact – as has been discussed earlier in this report, it is “intangibles” that are seen as the material drivers of value today.
A third way of determining adjusted book value is to consider what the market may pay at a “salvage” auction. Generally this is much less than even market value – Everybody wants a bargain, this method is also known to many as “Fire – Sale” price.
When consistently applied over time, adjustments help business owners determine with greater certainty true “realisable value” for assets or classes of assets.
Adjustments can be made for changes in value over time (both appreciation and depreciation). A practical example of these “adjustments” is the willingness of accountants (normally very conservative professionals), to systematically adjust the books to recognise changes in risk, technology, value of the dollar; or for changes in wear and tear of assets.
Due to the fact that any “adjusting” is based largely upon opinion, this method is always going to be open to debate and will rarely be accepted by opposing parties during any form of negotiation including when doing due diligence.
Valuations Based Upon Cash Flow.
The second category of valuation methods are by reference to valuations based upon the cash or income (profit) making potential of the business – Sometimes referred to as cash flow methods.
Multiple of Earnings or Income Approach.
This method is by far the most well-known and easiest method to understand. It is used by real estate agents and accountants as a “rule of thumb” method for providing guidance.
The starting point is to ascertain the profit before tax for a twelve month trading period. The method then multiplies that figure by anything from two times to nine times and even higher. Example – let’s say a small sandwich bar and lunchtime coffee shop returned a profit of $30,000 for a year. If we used a multiplier of say three times (3 x $30,000) the value of the shop would be $90,000.
This method is simple and straightforward. The debate occurs when owners who want the best sale price attempt to bump up the multiplier to 4, 5 or more. Or alternatively attempt to add back their wages, or Interest, or even suggest that they take most of the money out in cash or consumables so the profit figure should be inflated by these sums.
The “rule of thumb” is vague and unable to be substantiated… No-one I have ever met can actually point to any authorative text. It is compromised, certainly not accepted in market valuations for statutory purposes. Seldom accepted without encouragement to take into consideration (once again) intangibles like location, access to clients, newness etc.
Vagueness in interpretation.
When dealing with investors who are active in the stock market, this phrase (earnings multiples) has a different meaning, so it is important to be clear on what you mean when you use this expression. Do not use it in valuing shares.
Discounted Future Earnings.
This method approaches valuation by assuming the business will continue to operate and will year after year make profits (and sometimes losses). Secondly, that these future profits or earnings must reasonably be converted into todays’ monetary equivalent to arrive at a true value as at today.
By adding up or summing all future period profit (loss) and applying a discount rate to convert the future into todays’ equivalent dollar value, business value can be determined.
The method takes into consideration the “time value of money” i.e. any business investor would prefer to have the money today, rather than at some future time. The calculation “compensates” the investor for the time span involved.
The risk premium is a balance of opinion and crystal-ball gazing. The method can be hotly disputed by opposing sides because factual substantiation is improbable.
Discounted Cash Flow.
As with discounted future earnings, pure (actual) cash flows are estimated to continue to occur in the future, and when converted into today’s cash equivalent, can assist in estimating the value of a business.
This valuation method is generally used when attempting to value new businesses. A company that is presently selling product or services has some accounting evidence to provide certainty in respect of revenue, costs and net profit. A new business however has significant uncertainty in respect for the assumptions made leading up to “profit” Therefore using only cash flow, some of the uncertain assumptions are eliminated.
As with Discounted future earnings, the method is based on opinion, and perceptions of risk. The risk can be viewed from the perspective of risk outside the business such as industry risk, or risk of outside events impacting the industry; or risk inside the business. Significant debate can and does occur between parties on exactly how much to “discount” the numbers provided within the cash flow forecasts to cover all the risks.
An example of the application of discounted cash flow using excel spreadsheets is shown in this table.
Using the “Capitalised Earnings” approach is the most difficult to use, and to explain. However, it is the valuation methodology and process we use when being asked to provide an independent valuation report.
“Capitalised Earnings” reflects the position that any business should be generating sufficient profit after tax to return the owners investment.
When diligently and systematically applied, we have observed this model using quantitative and qualitative information to determine independently both the risk drivers and the value drivers present.
Firstly, it is necessary to work out the rate of return (interest rate) that will be used to reflect the business owner’s risk. Then the Future Maintainable Earnings (FME) are divided by that capitalized rate. The difficulties arrive in explaining the variety of mathematical formulas used for determining the rate, and then how FME or earnings or profit was arrived at!
The more risky the business, the industry and even the broader economy, the higher is the required rate of return that should be used.
Similarly, the calculation of the “true” income and costs can become quite complex. For example, income can be adjusted to reflect “free” cash flow, profit before tax, after tax, or before dividends or after dividends. It can and frequently is derived using EBIT, EBITDA, PEBITDA1
The true carrying value of the assets being used to actually earn the revenue is also open for debate. What should or should not be included is dependent upon the bias of the “expert” providing the opinion.
1 EBIT – Earnings before Interest and Tax. EBITDA – Earnings before Interest, Tax, Depreciation and Amortisation. PEBITDA – Proprietors Earnings before Interest, Tax, Depreciation and Amortisation.
Balancing Risk and Return.
All business owners confront risks in relation to earning their revenue. Valuations based upon future cash flows feature prominently in the valuation models used. Further, when confronting formal / legal disputes “capitalized earnings” helps in developing an understanding of the “Risks” to future cash flow and assists in presenting a defendable unbiased and systematic methodology.
Following, are some simple observations about risk drivers and value drivers that should be considered in the context of working out any valuation.
How you assess the risk to future cash flows should be clear. A final word of caution here; don’t rely upon biased data, and performing valuations at least annually helps determine trends.
Net Profit Margin %.
The Net Profit % is calculated by dividing Net Profit $ by Sales $.
The Net Profit – (whether it be “before tax” or “after tax”) is the monies available to be taken by the owners. Net profit is the reason we are in business, so there should be no argument as to the importance of this ratio.
There may be businesses that make better profits than others. There may be valid reasons why a profit figure is low or high, and there might be costs that are included or not included. Still, the actual measurement is an important first step.
ROCE – Return on Capital Employed.
The ratio ROCE is one of the most dynamic ratios used in business analysis. It links the Balance Sheet and the Profit and Loss, measuring the operational effectiveness between them both.
The ratio shows the relationship between Earnings (or more simply Net Profit – or when used by accountants various other “adjusted” bottom lines) and the Assets used to actually achieve the earnings. – Irrespective of the type of industry you occupy, the ROCE should be at least equal to the average interest rate, or if used, the WACC2. The ratio is arrived at as follows. Net Profit / ((Current Assets – Current Liabilities) + Non- Current Assets).
This ratio when used indicates that Company A is not only getting bigger profits, but needs a smaller investment in resources (the net assets) to achieve those bigger profits.
Calculated as Sales / Net Assets
This ratio measures how much revenue is gained by the assets needed to gain that revenue.
2 WACC – Weighted Average Cost of Capital
Company A makes more money, with a smaller investment in assets needed, and provides more cash at the end of the day to the owners. These examples have been created to highlight two main points.
Comparisons are important – whether it be comparison of a particular company’s progress over time – known as trend analysis. Or comparison of two companies, or even comparison with “best practice” “Industry norms” or desired outcomes.
Secondly, whatever the derived valuation of a business, it is important to satisfy yourself that the information you have received is meaningful to you.
When assisting business owners determine how much their business is worth we first seek to understand Future Maintainable Earnings – or that level of profit that we can reasonable assume the business can make next year and the years after that. Then we quantify the future risks confronting the business or the likelihood that FME will not be sustained. As we discussed, application of logical processes, systematically applied to both quantifiable and qualitative knowledge – backed up by court tested risk and value profiling is a business valuer’s “stock-in-Trade”.
The valuation methods and approaches do become more technical and the jargon used more complex. However, what you should take away from this report is that the methods that utilise Future Cash Flows and Capitalised Value (Risk) are applied when performing formal valuations – again because they are defendable in courts of law.
We use many financial ratios to supplement our knowledge and guide decisions. In this report we have offered just four key ratios and explained their importance.
The essential ingredient when conducting a business valuation exercise is the clear identification of exactly what is being valued. It is important to understand if it is the business, the assets within the business, the proprietorship, future profits, or future cash flows that are being used to estimate “business value”.
Just as important is the fact that all methodologies are opinion based, despite the very complex mathematical structures that might be used. I might also add that far too many people offering valuations provide opinions mistaken for fact.
The key or primary assets that create value in our economy are now the “intangible assets” such as people, processes, customers, and innovations. These things are difficult to measure and manage – but not impossible. A 2004 KPMG Study of fortune 500 companies revealed that the companies voted “best to work for” based on those companies attitude and care for employees and customers, were valued significantly above the market or equivalent businesses, some by as much as 50%.
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Introducing Kevin Lovewell – Accountant, Broker and Registered Business Valuer
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