In any discussion with an owner of a business something they will always want to know and very frequently raise is “what is my company worth?”. Whole textbooks have been written on the subject and as a result only a brief overview can be given here but hopefully enough for the basic principles to be understood so that some ball park figures can be calculated to allow for a more substantive calculation.
It is often said that company valuation is “an art and not a science” and this is very true. At the end of the day a company is worth what a buyer will pay for it – wide variations both above and below a technical valuation are not unusual. In turn there will be different valuations for different purposes and it is to be expected that two independent valuers acting on either side of a transaction will come up with significantly different values. In this respect the old joke of asking an accountant “what two plus two make – the answer being what do you want it to make?” is never more true.
There are however a number of tried and tested methodologies and those that are often most useful for family businesses are:
- Net assets as adjusted for open market values
- Earnings basis
The net assets basis is “what it says on the tin” using the net assets of the business as shown by the financial statements. Complications can arise when there are non business assets in the accounts such as surplus cash or investment properties but even here the basic principle holds true – the value of the company is the sum of the value of its assets less its liabilities. This of course does not take into account the value of “goodwill” and this is where the earnings basis comes in.
The earnings basis looks at the maintainable future profits and then multiplies those profits by an appropriate multiplier. In arriving at these figures there is huge scope for subjective assessment of the “numbers” to use. Where the earnings basis is less than net assets then it would be usual (but not an absolute given especially where the company is loss making) to use the net assets as the value. Where the earnings value is higher than assets the difference is by definition goodwill and the earning basis is likely to be the more appropriate.
The areas of most contention in deriving the earnings value include:
- Maintainable profits. A weighted average of recent results is often used as the basis for calculating this but there is always the question of whether it will be maintained especially where there is heavy reliance on a small number of customers
- Exceptional items. Maintainable profits should be “normalised” so as to exclude exceptional non recurring expenditure or indeed income. Examples would include redundancy or reorganisation costs or profits on the disposal of surplus assets
- What weighting should be used and indeed how many years should be weighted. The impact of management accounts and forecasts is also likely to be the subject of debate especially where there are significant variations in profit year on year
- Management reward. Maintainable profits are those after the payment of what is an open market arm’s length salary to those necessarily required to manage the company. In family businesses it is often the case that salary levels do not focus on market rates but on factors such as the best tax position or individual needs. The salaries charged to arrive at normalised profit may need increasing or decreasing by significant amounts
- Tax adjustment. Multipliers quoted in the open market – such as the FTSE 100 price earnings ratio – are calculated on post tax profits. While multipliers themselves can be adjusted to take account of the tax affect it is more usual to arrive at a post tax normalised profit and there is then the question of which rate of tax to use. It is usually the corporation tax rate but this does vary depending on the size of the company and government policy
- The multiplier to use. If the above factors have a fairly high degree of subjectivity, it is the multiplier that is subject to the most argument. What figure to use is influenced by many factors including the business sector and the size of the company and indeed the economic climate. There are a number of possible indices ranging from quoted FTSE indices to others such as the BDO PCPI. While these are often in the low teens, a more usual multiplier for a typical family owned business would perhaps be between 4 and 8 although in the current climate this may be seen as optimistic
The scope for significant variations in the values when seeking a formal valuation is clearly very evident and the first question a valuer usually asks is the purpose of the valuation. Is it for tax or to aid in settling a shareholder dispute or is it for divorce purposes or indeed to assess whether a buyer should be sought for the business and what a realistic price target may be. The objective and for whom the valuer is acting will determine whether the valuer seeks to minimise or to maximise the valuation and usually in the knowledge that it is the first stage in a negotiation.
A very simplified spreadsheet can be downloaded by clicking HERE to allow for your own circumstances to be applied.