Insider Media Limited

All answers are for general guidance only. Each case must be handled on individual facts.

Q: What are the different ways a business can be valued and the nuances of each option – asset valuation, multiple of earnings, cash flow, barriers to entry cost, and specific industry benchmarks?

Ultimately, a business is worth what a buyer is willing to pay for it. The buyer’s evaluation usually revolves around the level and reliability of future earnings - giving rise to valuation methodologies such as earnings multiples, turnover multiples or discounted cashflows. However, when the earnings are low or non-existent then asset-based or cost of entry valuations may apply.

However, a valuation is not an entirely arithmetic technical calculation. The buyer’s assessment of risk, reliability of earnings, ease of combination with existing operations or synergies are just a few factors which can affect a theoretical “text-book” valuation.

Taking each method in turn:

Multiple of earnings

A business is usually valued as a multiple of its “adjusted, maintainable earnings stream”. Earnings can be defined as pre-tax or post-tax profit, earnings before interest and tax (EBIT) or earnings before interest, tax, depreciation and amortisation (EBITDA).

The “adjusted, maintainable earnings stream” is not necessarily the profit shown in a company’s prior year statutory accounts. A number of year’s results need to be examined and adjusted to remove exceptional, extraordinary, non-recurring or non market rate income or costs. The resulting numbers and an understanding of the drivers behind them then enables a judgemental assessment as to what the true maintainable earnings are.

The multiple applied to the “adjusted maintainable earnings stream” can vary considerably, depending mainly on the future reliability of earnings. Factors which can affect this include whether the sector as a whole is growing or declining, whether past results have shown steady growth or are subject to unforeseen volatility, the extent to which supplies and sales are secured and underpinned by contracts, etc. For example, a business with its own IPR, a range of products and a large number of customers would be expected to command a higher multiple than one making a single customer-designed component for a sole customer.

The figure derived by applying a multiple to the maintainable earnings may then need adjustment to reflect matters such as borrowings or surplus cash in the balance sheet, and property assets included in the balance sheet at non-market values.

Multiple of turnover

This is effectively an earnings style valuation, very occasionally used in sectors where net profit is very predictable and closely linked to sales. Examples include Domino’s Pizza, computer maintenance and mail order businesses. This method is rather crude and is increasingly used only as a check to other valuation methods.

Discounted cashflows

This is a technical calculation of the current value of future cashflows, plus a residual capital value, discounted to today’s date. It depends heavily on the assumptions about long term business conditions and is rarely used in practice. It might apply to stable, mature, cash generative businesses such as a publisher with a large catalogue of titles.

Assets or cost of entry

These methods apply when the market value of the net assets, or the cost of setting up a business, exceeds an earnings based valuation. It is more likely to apply in asset rich sectors like property or engineering companies, or in situations where the business is in financial difficulty.

Industry specific methods

Certain industries use specific metrics to value businesses in that sector. Examples include a number of weeks’ turnover for Domino’s stores, a multiple of customer numbers for mobile phone airtime providers, etc.

Summary

Valuation of a company is a complex area requiring careful analysis of the robustness of its financial performance, and intuitive assessment of the strength of the buyer market. The work usually combines technical calculations with more commercial assessments of past deals in the sector and the appetite of acquirers. Expert help specific to the particular circumstances being looked at is strongly recommended.