Business Valuations

There are 5 methods of valuing a firm…

  1. Asset Valuation where the value of the firm is the value of its tangible assets like plant, building, machinery, fixed assets, inventory etc. Asset valuations might be undertaken for a number of reasons, but the most common is when a firm is quitting the industry, or is merging its assets with that of a another firm.
  2. Earnings Based Valuation (Earnings Valuation or Shareholder Value) which values the firm as a going concern. Earnings valuations use Discounted Cash flow methods to value the future ‘Free Cash Flows’ of the company, and the terminal value of the company inked to terminal growth and the lifecycle of the firm. These are then converted if need be into revenue multiple or Earnings Before Interest and Tax (EBIT) multiples commonly used in relative valuations.
  3. Relative Valuations which are simplified thumb rules of revenue and EBIT multiples by industry, extracted from Earnings Valuations conducted on a set of selected firms representing the industry.
  4. Contingent Claim Valuations which are contingent on the value of another underlying asset. The science of real option analysis for risky projects or assets whose value is contingent on the increase in value of another asset are typical examples.
  5. Future Maintainable Earnings which act as a proxy for the earnings valuations particularly for smaller companies (like SMEs) where the ability to ascertain the cash flows is unreliable, or the ability to derive the perpetual value of the firm is tenuous.

Key benefits of carrying out an earnings based valuation and/or contingent valuations are…

  • They allow firms that are going concerns to value their ability to generate free cash flows in the near and far term.
  • They make an estimate of the WACC and the ability of these future free cash flows to create wealth.
  • They estimate the terminal value of the company and therefore capture the effect of the company’s intangible assets like branding, intellectual capital, etc.
  • They permit the owners an intelligent and economical way of transiting from the business.
  • They provide for effective succession planning with SMEs.

Allan Rodrigues of The Business Binnacle specialises in Business Valuations and valuations derived from cash flows. You can contact him at allan@theBusinessBinnacle.co.nz [no spam]

Earnings Valuation Methodology

Earnings Based Valuation (Earnings Valuation) value the firm as a going concern. The aim is to make an intelligent projection of the ability of the firm to capture its intellectual capital, intellectual property and/or competitive advantage as ‘Future Free Cash Flows’ over a fixed period (a reasonable time horizon commensurate with the environment the firm operations in) plus a ‘perpetuity’ or terminal cash flow that captures the life cycle position of the firm.

Free Cash Flows are defined as those cash flows that are available to the providers of finance (debt and equity) after adjustment for Replacement Capital Investments (to replace ongoing assets), Incremental Capital Expenditure (CAPEX) and Incremental Working Capital needed to grow the firm. These cash flows are then discounted at a discounted rate represented by the WACC.

Weighted Average Cost of Capital (WACC) is the cost of capital funding (See WACC) weighted for the capital structure of debt and equity. The WACC is therefore a critical component of valuation and the creation of wealth, as it estimates the opportunity cost (and a premium for risk) that would be needed to given to the providers of finance (Debt and Equity). It captures this return to the investors (equity and debt holders) as a cost, as it represents a cost to the firm.

WACC calculations contain key elements like the ‘Risk Free Rate’ on government bonds, an estimate of the Market Risk Premium (sometimes called the systematic risk), the unique or unsystematic risk of the firm (also called the Beta) and the debt interest rate adjusted for the tax shield available to debt. In Australia and New Zealand the WACC includes an adjustment for imputation credits as well.

The Free Cash Flows of the firm over a reasonable time horizon plus the perpetuity value of the terminal cash flows are combined to form the ‘Shareholder Value’ or Earnings based value of the firm.

Earnings valuations are valid for going concerns that are able to justify their projection and face reasonable due diligence on the key value drivers of the firm. When this occurs an earnings based valuation is vastly superior to standard relative valuations as they…

  • Capture the value of the firm based on intelligent assumptions of key value drivers. These assumptions can then be tested by a willing buyer and a willing seller to arrive at a consensus value.
  • Can be used to measure the value gap between project value and actual value achieved and measure which drivers have created or destroyed the value of the firm and why (See 4G Balanced Scorecards).
  • Individualise the firm and capture the manner in which the firm chooses to compete (as against Relative Valuations which provide a relative Revenue Multiples, or EBIT multiples which use the same yardstick for measuring good or bad companies).

They are a key ingredient of 4G balanced scorecards that use the current and future projections of share price as Value Advisory Services.

Allan Rodrigues of The Business Binnacle has considerable experience in earnings valuations particularly for firms and organisations operating under risk and uncertainty. You can contact him at allan@theBusinessBinnacle.co.nz [no spam]

SME Valuations

SME Valuation techniques are a trade off between the size of the SME (and therefore the costs it can bear to pay for a valuation), and the need to capture the performance of an individual SME performing well, or the benefit of a cutting edge innovation that would be undervalued by standard Relative Valuations (Revenue and EBIT multiples) used by valuers in the market place.

SMEs in mature markets with little difference in how they operate with respect to their industry are best advised to use the Relative Valuation Technique (revenue multiples, EBIT multiples, etc) provided by most business brokers.

SMEs that have either grown significantly or are confident of sustaining their competitive advantage should use the Future Maintainable Earnings method which is a half way house to a full scale ‘Earnings Value’ of the firm. This makes their value proposition visible to prospective buyers (See Earnings Valuations above) and allows them to capture the Shareholder Value they have created before they exit their businesses.

SMEs at the cutting edge of innovation invariably find themselves ‘racing for the future’ and in a position where they are looking for a large player to partner with to take them to the world at large.

Learning to make strange bedfellows with a crocodile is an art form they need to develop to stay ahead of the game and protect their interests. Earnings valuations supplanted with Contingent Claim Valuations provide a fairly good way ahead for such SMEs, as they allow them to capture the value of future earnings in a way that mitigates their risks. Structuring these Strategic Alliances in a way that allows these SMEs to share the risk whilst preserving the upside value of their innovation is critical.

Allan Rodrigues of The Business Binnacle specialises in growing cutting edge companies and in strategic alliances and joint ventures between SME’s and large players in the marketplace.

You can contact him at allan@theBusinessBinnacle.co.nz [no spam]


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