Business Valuation | Simkover and Associates Chartered Accountants
There are various reasons for valuing a business, the most common one being that a business owner wants to sell the business as a going concern and needs to know how much to charge for it. This implies that the business has built-in goodwill such as faithful customers, experienced and loyal employees and a long-standing reputation in the industry. A buyer is willing to pay for these intangible assets because it would otherwise take a long time to build these up from scratch when starting up a brand new business.
Another reason for valuing a business is a buy-out of one partner by the other partner for half the current value of the business. There are many other possible reasons as well, but in most cases the assumption is that the business will continue in a similar fashion after the sale. This is the most critical factor in the valuation analysis, since the valuation methodology is generally based on the forecasting of future profits and cash flow, which are usually calculated by projecting recent profits and cash flow into the future. This type of valuation approach is only workable if the company is expected to be profitable in the future. If not, it may be more practical to calculate liquidation value of the company's assets like equipment, furniture and vehicles and compare to outstanding debts of the company.
For profitable companies, there are various valuation techniques of which we will discuss two in this article. The first is the discounted cash flow method. Cash flows for the next five to ten years are forecasted, based on current cash flows adjusted for expected changes. For example, current sales are expected to increase 10% per year for specific reasons that can be explained and supported by plans for increased advertising, capital equipment spending and expansion of warehouse space. In turn, the current expenses are forecasted higher to take account of the specific cost increases just mentioned. Income tax rates may be expected to decline over the next five years if the government has announced specific plans for corporate tax reductions, so this would also be reflected in the cash flow projections. Using a discount or interest rate appropriate for the business risk and growth opportunities applicable in the particular situation, each future year's projected cash flow is brought back to the present time with the discount rate. The sum of all the future cash flows represents the present value of future cash flows and is considered to be an estimate of the current value of the company. Various factors like the expected departure of certain key employees and/or the current owner may negatively affect the future cash flows, but these and all other factors should be taken into account when forecasting the future cash flows. It is important to realize that the forecast of future cash flows is often quite far off from the reality that eventually occurs, and therefore it is appropriate to use sensitivity analysis to obtain an upper and lower threshold of possibilities for revenue and expenses. This will in turn result in an upper and lower threshold for the valuation of the company. Note that there are other factors that come into play in the discounted cash flow method, but we have covered the primary ones involved.
The second method of valuation that we will discuss is called capitalization of earnings. It is a more simplified method but can be used in addition to the above method for purposes of comparison. Under this technique, we are assuming that the future earnings of the company will continue far into the future on a consistent basis. The future annual earnings are calculated by starting with current annual earnings and then adjusting for all kinds of factors which would cause the future post-acquisition annual earnings to vary from the current annual earnings. There are many adjustment factors, some of which are as follows: excessive current remuneration to owners, excessive personalized costs of current owner such as travel, entertainment and automobile costs, excessive bad debt costs, high current financing levels and interest rates, and the expected impact of a new product line to be introduced after the acquisition. Once we have adjusted current annual earnings to expected future annual earnings, income taxes are deducted at the expected future tax rate to arrive at after-tax future annual earnings. This entire approach is done on a sensitivity basis so that we end up with a range of possible future annual after-tax earnings rather than just a precise number, in order to account for the uncertainty and the error factor in calculating these amounts. The future annual after-tax earnings are then multiplied by a "price/earnings multiplier" to arrive at the going-concern value of the operations. The multiplier to select is highly subjective and is affected by a host of factors such as stock market trends, technology, market position and opportunity for the company, labour rates, inflation expectations, etc. However, low price/earnings multipliers are associated with uncertainty in the level of anticipated earnings, and high multipliers are associated with above-average prospects for growth of earnings. For small private businesses, multipliers of 4 to 6 are typical. After arriving at the going-concern value of the operations, we add an estimated value for any redundant assets which are being sold along with the business, such as unused land, since such assets have not been built in to the calculation based on future estimated earnings. Then the total value represents the estimated value of the company, for which we should have a range based on our sensitivity analysis.
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