Insights

Overview of Valuation Methods

March 27, 2019 //

Correctly valuing a business is central to any successful M&A transaction. As much art as science, valuation strives to quantify the financial benefits of owning the business today and in the future. Here we kick off a series of articles examining different valuation approaches, limitations, and best practices. This piece introduces the core principles of valuation, components of business value, and most common methods used to assess it.

 

Core Principles

Which will yield greater contribution to equity holders: liquidating the business’s assets, or operating it as a going concern? The answer lies in comparing (a) the value of the business based on the cash flows it is expected to generate discounted to reflect the associated risk, and (b) the estimated net proceeds that could be realized by selling the underlying assets and settling all liabilities.

This foundational question gives rise to the two most common valuation approaches: income or cash flow-based, and asset-based. If a business is viable on as stand-alone basis, valuing it as a going concern based on its cash flows will generally be more appropriate and yield a higher value.

With this as a starting point, let’s look at some of the core principles of valuation which apply across private and open-market transactions, reflecting economic theory, common practice, and legal precedent[1]:

  • Value is specific to a point in time, reflecting available information and reasonable expectations at that time.
  • Capital Structure. Value should be independent of how a business is financed, so enterprise value is calculated assuming a “normalized” capital structure, before debt servicing costs.
  • Cash Flow. For an economically viable business, value is mainly a function of future discretionary cash flows.
  • Rate of Return. Market forces – including economic conditions, borrowing rates, the market’s view of an industry’s growth prospects, competitive landscape and risks, and company-specific risk factors – determine the required rate of return built into valuation models.
  • The more liquid a business or equity interest (i.e., the number of prospective buyers at the relevant point in time), the higher the value.
  • Higher Net Tangible Operating Assets will tend to support a higher valuation, even when using cash flow-based techniques, as they imply barriers to entry, greater access to debt financing, inherent liquidation value, and lower risk than intangible assets (i.e., goodwill).
  • Commercial and Non-Commercial. Commercial (i.e., transferrable) and non-commercial (i.e., specific to an owner) value are distinct concepts, with the latter accounting for differences in what prospective buyers may be willing to pay for a business.
  • Controlling vs. Minority Interest. The controlling interest in a privately held business may have a higher value per share than a minority interest in the same company; this is not typically the case in publicly trade companies, whose minority shareholders have access to a liquid market.

 

Components of Business Value

The enterprise value of a business is its total value, including both its interest-bearing debt and equity components. It is the total value of:

  • Interest-bearing debt and equivalent liabilities
  • The value of all outstanding shares, or the owners’ equity, often referred to as the “intrinsic value” of the business. This in turn is comprised of:
    • Adjusted net book value, i.e., tangible operating assets less liabilities
    • Intangible value, including identifiable intangible assets (e.g., brand names, patents, copyrights etc.) and non-identifiable intangible assets, or goodwill
  • Any incremental value above the intrinsic value, as perceived by a buyer, resulting from expected synergies or other economic benefits that are not available to the business on a standalone basis. Intrinsic value plus expected synergies is known as “strategic value”.

Introduction to Valuation Methods

Cash Flow-Based

Because of their ability to reflect the future economic benefits of an ongoing business, cash flow methodologies are most commonly used in business valuation. There are various ways to estimate value based on cash flow – each with its unique benefits and limitations – including applying a multiple to an income number like EBITDA, capitalizing cash flows, and discounting cash flows. All of these methodologies require:

  • An estimate of prospective future cash flows, with discretionary cash flow considered to be the most accurate measure
  • Determination of the risk involved in achieving those cash flows, which is then expressed as a rate of return (discount rate or capitalization rate), or valuation multiple
  • The deduction of interest-bearing debt and equivalent liabilities from the enterprise value, which normalizes the capital structure and yields the equity value of the business
  • An assessment of the business’s underlying net assets, and adjustments to reflect excess or deficient net operating assets, as well as redundant assets (e.g., owned building or plane)

Figure 1 summarizes the cash-flow based approach to valuation.

The art and judgement in this type of valuation lies mainly in determining prospective cash flows and the appropriate level of risk to apply. Note that the same enterprise value can be calculated using a conservative cash flow number and lower risk level or a more ambitious cash flow and higher level of risk.

Asset-Based

We use asset-based valuation methodologies when a business is not viable as a going concern, where it is more practical for an owner to dissolve rather than sell a small company, or for capital-intensive businesses where the net asset value may exceed the present value of cash flows. The most common asset-based methodology calculates the liquidation value, though in some cases adjusted net book value or real estate valuation are used.

Liquidation can be either forced (e.g., when a failing company goes into receivership) or voluntary, and take place either immediately or over an extended period of time. Voluntary liquidation typically involves circumstances more favourable to the owner, and yields a higher valuation. When liquidation takes place in a relatively short period of time, it is considered less risky and avoids prolonged overhead expenses, often resulting in a higher valuation than a more extended process.

Under the liquidation value methodology:

  • Assets on the balance sheet are restated to reflect their current net realizable values (sale price less disposition costs)
  • Liabilities are deducted from the expected proceeds resulting from the sale of the assets, normally at face value
  • Liquidation cost are deducted to calculate the net proceeds before income taxes
  • Corporate income taxes are deducted, resulting in the “proceeds available for distribution”, or liquidation value of the business

Industry or Business Model-Specific Asset Based

Occasionally we see a buyer focused entirely on the acquisition of an industry or business model-specific asset, like nursing home beds or hot water tanks or subscriptions for a service or product. In particular, “The subscription business model is booming. Previously dominated by the likes of newspapers, magazines, gyms, utilities, and telecommunications firms, … business-to-consumer subscription businesses have attracted more than 11 million U.S. subscribers in 2017, and the industry as a whole has been growing at 200% annually since 2011.”[2]

In a sense, these are both cash flow and asset-based valuations. Typically, we build revenue and profitability per asset unit, costs of acquisition, rates of turnover, etc. into our cash flow and risk assumptions. We also look at the multiples applied to the specific asset in comparable transactions.

In the coming articles we will drill down further on the most common cash flow-based valuation techniques. We will examine the popularity and limitations of the EBITDA multiple, and dig into the income statement and balance sheet adjustments that can paint a more accurate picture of business health and prospective cash flows.

[1]Principles from H.E. Johnson, Business Valuation, 2012.

[2] D. McCarthy and P. Fader, “Subscription Businesses Are Booming. Here’s How to Value Them”, hbr.org, December 19, 2017.