As of last week, Microsoft ($850bn) had overtaken Apple ($847bn) as the world’s most valuable publicly-listed company, 16 years after the software giant lost its crown in the wake of the dotcom crash. It’s an interesting one in terms of business valuation as Microsoft is trading at c. 24 times expected 2019 earnings whilst Apple is trading at c. 13 times what analysts think it’ll generate in 2019. This means Apple makes more money than Microsoft, but investors are currently willing to pay more for each dollar of Microsoft’s earnings.
Why might this be?
The discussion around business valuation is always a topical one and can often involve a certain amount of emotion, especially when an owner is evaluating their own business.
Unfortunately, there are no hard and fast rules when it comes to determining the value of a business but there are some generally accepted methodologies and principles which can be applied to provide an indicative valuation for a trading entity.
This article aims to provide a high-level overview of the above and whilst every effort has been made in preparing this article, we strongly recommend that specific professional advice and guidance be sought for a more detailed appraisal of each individual business.
When are valuations needed?
A valuation may be required in various circumstances, including the following:
• Preparing a business for sale / exit planning
• Evaluating an offer received for a business
• Analysing an acquisition opportunity
• Obtaining debt or equity financing
• Gifting of shares to family or employees
• Company restructuring
• Estate planning
• Death of a shareholder
• Shareholder or marital disputes
• Insolvency or bankruptcy matters
An important point to remember is that any professional valuation is only a best estimate and the true value of any business can only be determined by what a willing purchaser is prepared to pay the vendor on the open market.
Notwithstanding this, a number of different valuation methodologies can be used to place a value on a trading business with some of these methods being more respected than others. This article focusses on the most commonly applied method, Future Maintainable Profits capitalised by a suitable multiple.
Multiple of Future Maintainable Profits (FMP)
FMP are the most important aspect of any business valuation as they reflect the fact that the value of any trading business lies in its future profits.
This valuation methodology then applies an appropriate multiple to the FMP to capitalise those earnings into a value for the business (on a debt-free, cash-free basis).
The first step in a business valuation is establishing an accurate figure for FMP. FMP are calculated by reviewing the company’s reported and projected profits and making adjustments for abnormal, non-commercial and non-recurring items.
As noted above, any purchaser, hypothetical or otherwise is buying the future potential of the business and therefore FMP should be based entirely on future free-cash flows and a review of all information and adjustments should be carried out in this light.
Readers of this article are likely to have knowledge of EBIT (Earnings Before Interest and Tax) and EBITDA (Earnings Before Interest, Tax, Depreciation and Amortisation). Like FMP, both EBIT & EBITDA are two commonly used earnings variants used within business valuations.
However, care should be taken when using either of the above to value a business.
For example, if a business requires an average capital spend each year of 50% of net profit, it’s clearly not going to be appropriate to add back the entire depreciation charge when deriving maintainable free cash flows. As Warren Buffett once said in reference to EBITDA – “Does Management think the tooth-fairy will pay for cap-ex?” Therefore, in capital-intensive industries, EBITDA can be a near meaningless metric.
Our preference at CavanaghKelly is to review the particular circumstances of each engagement with a view to establishing a fair and reasonable figure for FMP. This is then applied to an appropriate multiple.
Establishing the Multiple
The multiple, or capitalisation factor, will reflect the rate of return a prudent purchaser would reasonably require in light of the growth potential and the risk factors inherent in the business.
In broad terms, the lower the risk, the higher the multiple.
Therefore analysing the profile and drivers behind FMP is the predominate factor in valuing a trading business with the process being a trade-off between expectation and risk in regards to the likely continuity and/or development of the FMP.
Referring back to the Microsoft (25 x.) versus Apple (13 x.) example above - some analysts suggest that Microsoft is currently trading at a greater multiple than Apple due to its more diversified sales portfolio (PC operating systems, software products, X-Box franchise and cloud computing) whereas over 60% of Apple revenues are generated from the iPhone. In addition, analysts also expect Microsoft to deliver more robust growth over the next few years.
When considering the multiple, the following factors should be reviewed to identify growth potential and risk around future cash flows:
• the company’s historic and projected financial performance
• the attractiveness of the sector in which the company operates and the strength of its market position and market share
• the company’s customer’s – recurring base, loyalty, concentration, contracts
• the company’s competition – present, future and barriers to entry
• the strength of its management team (and reliance on same if not staying on)
• the size of the company
• the quality of its earnings
• the geographic location
• the company’s asset base
• the company’s intellectual property
• the potential purchaser synergies
• the company’s premises, capacity and tenure and
• the current and forecasted economic and political climate
The above list is not exhaustive and care must also be taken not to reduce/increase both the FMP and the multiple when reviewing the above considerations.
In addition to the above business specific matters, it is often advisable to review the following more general information:
Comparable transaction multiples – recently completed deals should also be reviewed in conjunction with the above to give an indication of pricing and trends in the market. Valuation indexes can also be evaluated to provide a further review mechanism, such as the PERDA and UK200 Group index.
Stock-market multiples – In some circumstances, we may wish to consider the earnings multiples of publicly quoted companies that may be comparable in terms of sector, size, geographical location and financial performance. You should note that an appropriate discount will almost always be applied if valuing a private company when compared to those on the markets.
Industry ‘Rules of Thumb’ – These can also be analysed but care must be taken as every business is different and no assumptions should be made in respect of multiples applying across an entire sector.
To summarise, when carrying out a valuation, all of the above should be considered with the particular circumstances dictating the appropriate multiple for that business.
Bringing it all together
A high-level working example of the above FMP valuation methodology is shown below for illustrative purposes only:
Calculation and weighting of FMP
|Joe Bloggs Limited||FY17 filed £'000||FY18 filed £'000||FY19 proj £'000|
|Non-recurring prof. fees||15||20||-|
|One-off pension contribution||-||20||10|
|Exceptional bad debt||-||25||-|
|Loss on Foreign Exchange||12||6||-|
|Other extraordinary items||-||15||-|
|Commercial cost for Director||(50)||(50)||(50)|
|Profit on disposal||(11)||(11)||-|
|Notional rent on property||(50)||(50)||(50)|
|Weighted Average FMP||100%||300|
NOTE: it may not be appropriate to ‘weight’ the FMP as shown above in every scenario. Depending on the circumstances, more weight may be applied to future or historic trading financials or often a simple average can be used.
In this example, the weighted average FMP of £300K is then applied to the chosen multiple of 6.0 to arrive at the cash-free, debt-free business valuation of £1.8M as shown below:
|Chosen multiple (following review)||6.0|
You should note that the above example does not necessarily reflect what cash an owner would receive ‘in their hand’ if they were to sell their business, as the above is based upon the assumption of a debt-free, cash-free position.
In order to arrive at an equity valuation (or share valuation) consideration must be given to surplus cash, surplus assets and the company’s current debt position. Normalised working capital adjustments may also need to be considered.
Minority shareholding discounts may also have to be considered if valuing less than 100% of the company.
When business owners are considering future plans it is greatly beneficial for them to understand the important drivers behind their business valuation. As noted above, every business will be different and therefore we recommend that professional advice and guidance be sought for a more detailed appraisal of each case. CavanaghKelly can assist you in this process.
Whether buying or selling or any of the other circumstances noted above, an advisor knowledgeable and experienced in determining value and price will be able to help you navigate the complexities of valuation.
Should you wish to engage us in relation to preparing a business valuation or discuss any of the matters in the above article, please do not hesitate to contact Michael Drumm.
Whilst every effort has been made by CavanaghKelly to ensure the accuracy of the information here, it cannot be guaranteed and neither CavanaghKelly nor any related entity shall have liability to any person who relies on the information herein. Information given here is for guidance only. Detailed professional advice should be taken before acting on any information contained herein. If having read the guidance here, you would like to discuss further; a member of our team would be pleased to help you.