Valuation methods typically include:
- Discounted Cash Flow (DCF)
- Capitalisation of Future Maintainable Earnings (CME)
- Net Tangible Assets on a going concern basis
- Orderly Realisation of Assets
- Capitalisation of Future Maintainable Dividends
DCF Method
The DCF method is the present value of expected future cash flows of a business discounted at a rate that reflects the time value of money and the risks associated with business.
This method requires the forecasting of cash flows over a suitable period of time, the analysis of these future cash flows, the capital structure and cost of capital (discount rate), and an assessment of the residual value of the business remaining at the end of the forecast period.
Theoretically, an asset is worth its future cash flows. Therefore, a DCF valuation is in theory the soundest methodology. However, it is often difficult to apply in practice due to the lack of reliable information about future events. This valuation method is appropriate for a start-up or growth business, a business with a finite life and/or a business that experiences volatile cash flows.
Where the cash flows of a business is predicted to grow more or less uniformly in the foreseeable future there is little point in doing anything other than a capitalisation of the future cash flow stream / earnings because the derived result will be much the same.
CME Method
The Capitalisation of Earnings method of valuation requires the calculation of the expected future maintainable earnings from the business. The emphasis on maintainable earnings relates to the prospect of them continuing into the future.
Capitalisation of earnings is the most commonly used method for the valuation of profitable businesses. Although it can be difficult to adopt for businesses experiencing high levels of growth or those with anticipated high capital expenditure requirements.
In assessing the value under an earnings basis, it is necessary to consider both the historical earnings of the business conducted and the expected level of future earnings.
It is necessary that the historical results of the entity be restated to take into account any abnormal or extraneous items, and where appropriate, to restate related party transactions to a commercial level. In addition, any income / expense not related to the core business, such as interest expense and interest income, should also be removed from the entity’s earnings as such items generally relate to assets that have a different risk profile to the core business operations.
An appropriate earnings multiple is then applied to the estimated maintainable earnings before interest and tax to determine the value of the core business. Such a rate will depend upon a number of factors including the inherent risk of the business as well as external factors such as the industry and economy in general. This is particularly subjective in that it has to reflect appropriate risk factors associated with the particular entity.
The business value determined is then adjusted by any non-operating assets / liabilities (such as loans) to determine the value of the entity.
Net Tangible Assets – going concern basis
This method is used where the business is financially viable but its profitability is insufficient to where it is considered that it does not generate a reasonable return on its assets for the associated risk, that is, the CME assessed value is less than the net tangible operating assets of the business.
Orderly Realisation Approach
If the business is not financially viable, then the value of the assets should be on an orderly realisation approach.
Capitalisation of Dividends
This relates to a minority interest holding in limited circumstances. It assumes the shareholder will not have access to the retained earnings of the entity and a pattern of dividends has been established.
The CME Valuation process
As this is the most common methodology we adopt, we set out the process of a CME valuation.
- Obtain the financial statements for last few years and the budget for the current year.
- Summarise the most recent balance sheet and separate it for:
- Operating tangible assets and liabilities
- Non-Operating assets and liabilities such as surplus cash, personal motor vehicles, shareholder and bank loans and hire purchase liabilities. Note the level of surplus cash represents cash not required to operate the business. It depends on the working capital requirements of the business.
- Recorded intangible assets
- Restate the book assets to market value – write-off non-recoverable loans, plant & equipment at market value, include unrecorded liabilities such as employee entitlements, etc
- Summarise historical and budgeted profit and loss.
- Adjust for:
- Interest received
- Interest paid and hire purchase charges
- Amortisation
- Commercial remuneration for owners
- Commercial rent if property is owned by a related party
- Depreciation to expected on-going capital expenditure levels
- One off, non-recurring items such as legal fees, bad debts
- Discretionary expenses such as donations, some travel, etc.
- This derives restated Earnings Before Interest and Tax for each year.
- To assess the maintainable earnings before interest and tax (EBIT) of the business:
- Assess maintainable sales – If trending upwards or downwards, the most recent sales is the most likely indicative of future trading. If oscillating up and down each year, average of several years. Did one-year relate to a large one-off contract?
- Gross profit % – look at consistency and trend, reliance on imports and movements in exchange rates
- Assess based on a review of prior years
- Assess which expenses are variable to sales – freight, salaries, etc.
- Determine future maintainable EBIT. How does it compare to the restated EBITs of prior years?
- The assessment of the capitalisation rate / earnings multiple is not an exact science and is highly subjective.
- In assessing the appropriate EBIT multiple to apply to a SME consider:
- What are the typical earnings multiple ranges for businesses of similar nature and size.
- How long has it been established / consistency of revenue and profitability
- What phase is the industry that this business is in: growing, established, mature or declining?
- Is revenue of a one-off nature or is revenue from clients reccurring? Recurring revenue has a higher multiple.
- The actual growth record and expectations of the business. The higher the growth expectations, the higher the multiple.
- The spread of customers – any reliance on a few key clients? The higher the reliance on a customer, the lower the growth.
- Reliance on any one or two suppliers. Any distribution agreements – terms of such.
- Is location important to the business – what are the lease terms?
- How dependent is the business on the owner and key staff? Typically this is a key issue with SMEs.
- State of the industry – level of competition
- Reliance on key contracts.
- Any major capital expenditure in short to medium term.
- The specific strengths and weaknesses of this business.
- The cyclical nature of this business
- Often a valuer derives a range of earnings multiples. Say, 3.0 to 3.5 x EBIT.
- There is little public data available on applicable EBIT multiples for SMEs. Having business broker contacts can be useful.
- Assess the value of the business / enterprise by applying the multiple to the assessed maintainable EBIT.
- The resultant goodwill / intangible value is determined by deducting the net tangible operating assets from the assessed business / enterprise value. Does it look reasonable? Are there any rule of thumbs to compare it to such as Cents in Dollar of Revenue (used for accounting firms) or Price to Assets ratio? Is any of the resultant goodwill personal in nature and non-transferable? If so, amend the valuation.
- Assess the value of the entity (as distinct from the enterprise) by adjusting for the net non-operating assets.
- Note, some valuers use Earnings Before Interest Tax Depreciation & Amortisation (EBITDA) as the basis for their CME assessment. For SME valuations, we prefer to use EBIT and EBIT multiples as this correlates more with the actual cash flow of the business. We consider EBITDA is more applicable for larger valuations where there is reference to the EBITDA multiples of listed companies in the same industry. They use EBITDA rather than EBIT mainly due to the potential of varying depreciation policies of the listed companies concerned.
Our Accredited Specialists
Joshua Wheeler – director is recognised as a Business Valuation Specialist by Chartered Accountants Australia & New Zealand (CAANZ).
Victoria Wheeler – director is recognised as Business Valuation Specialists by CAANZ.
Russell Munday – now a consultant to Munday Wilkinson, is formerly recognised as a Business Valuation Specialist and also a Forensic Accounting specialists by Chartered Accountants Australia & New Zealand
We have other professional staff who assist in the preparation of our reports.
Our Aim
Munday Wilkinson, trading as MW Forensic, is a boutique business valuation and forensic accounting firm established in June 2000.
We offer the legal profession, and others, a quality, personalised, time efficient and cost-effective service.
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Although every care has been taken in preparing this blog post, no responsibility is accepted by Munday Wilkinson Pty Ltd for errors or omissions. Professional advice should be sought before applying the information to particular circumstances.
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