Business valuations may be performed for a variety of purposes, such as family law proceedings, commercial litigation, succession planning, mergers and acquisitions, introduction of a new shareholder or legislative requirements. There may also be a distinct objective for a valuation, such as confirming a value already set or establishing a value, providing an alternative opinion to a valuation already obtained or to develop a negotiating position.
Valuations are generally carried out at fair market value, however there will be circumstances from time to time when an acquirer is willing to pay in excess of this value for special and strategic reasons. This is known as special value.
The business valuation method used will depend on the purpose and objective of the valuation, the size and type of business, and other individual circumstances. There are a range of methods that may be used, some of which will be more appropriate to one situation than another.
In general, a business valuation will use a primary method, then a secondary method as an appropriate cross-check.
Discounted Cash Flow Method
The Discounted Cash Flow (DCF) method is recognised as technically the most superior methodology, as it allows for fluctuations in future cash flows to be recognised in its calculations. Using this method, the value of the business is determined by net present valuing the estimated future cash flows such cash flows including a terminal value.
DCF is appropriate for valuing business with finite lives, new projects with high growth until maturity and existing projects entering high growth or expansion phases. A DCF valuation takes the cash flow generated by the business and discounts it back to a current value at an appropriate discount rate reflective of a required rate of return.
In order to use this methodology, at least five, but preferably ten years, of reliable projected future cash flows are required. Any estimation of future cash flows is always a challenging process and requires reliable financial information that can be adequately supported. It also requires considerable professional judgement in determining a discount rate.
Capitalisation of Future Maintainable Earnings Method (FME)
This methodology is appropriate for valuing businesses that are mature and reasonably established, with a proven track record and expectations of future profitability, and relatively steady growth prospects. This approach would not be generally effective for businesses with a volatile earnings history, in a start up phase or in a winding up stage.
Basically, the value of the business is determined by capitalising future maintainable earnings. A variant of this method involves the capitalisation of FME before interest and tax (EBIT).
The EBIT approach eliminates the potentially misleading effects of unusually abnormal or non-business related debt levels in the corporate entity which operates the business. The actual debt attributable to the corporate entity is dealt with separately in the value of the corporate entity.
Using this method requires consideration of the following:
(i) selection of an appropriate level of future maintainable EBIT having regard to historical and forecast operating results after adjusting for non-recurring items of income and expenditure and any other known factors likely to affect the future operating performance of the business. Earnings arising from assets surplus to the operation of the sustainable business are eliminated and the assets, net of any liabilities relating thereto, treated incrementally.
(ii) determination of an appropriate earnings multiple having regard to factors such as the market rating of comparable companies, the type of industry, the extent and nature of competition in the industry, quality of earnings, future growth opportunities, asset backing and relative investment risk.
Net Assets Backing Method
This method assumes an orderly realisation of the net assets of the business and is appropriate where the business is currently operating at a loss but may no longer do so in the future, and where the break up value of the business would exceed the going concern value.
This method is complementary to the capitalisation of earnings techniques because it provides an insight to the value of the intangible assets of the business being valued.
Some considerations when basing a valuation on this methodology are whether the depreciated value of the plant and other assets is an appropriate reflection of current value, or if a revaluation of these assets is required, whether a separate valuation of any special plant is required, and whether any real property exists, such as land and buildings, as these may need to be valued by a licensed valuer.
Rule of Thumb
The “rule of thumb” methodology, also known as the “industry multiplier” methodology, uses standard industry models to value a business. Generally, the business is valued as relative to an industry standard. This is most appropriate for franchises and industry sectors with a firmly established valuation model.
This methodology is therefore only suitable for businesses that operate on par with the industry average. For businesses that vary significantly from the industry standard, there is no benefit in using this method.
Capabilities
Lawler Partners has a dedicated Forensic team experienced in a wide range of valuations. If you have any queries in relation to business valuations, please do not hesitate to contact Mr Raymond Tolcher of our Newcastle office on (02) 4962 2294.
