April 21, 2000 8:15 AM PDT
Patience-to-Earnings ratio wears thin for dot-coms
By Tiffany Kary
Staff Writer, CNET News
.With the Nasdaq well below its March 10 high of 5,048, investors are finally asking what the 'E' in the P/E, or price-to-earnings ratio, means.
Although profits suddenly mean something to dot-com investors, some analysts and executives maintain Net companies still need leeway to build out their businesses.
Do profits matter?
The profit tug-of-war will determine the direction of Net stocks for the foreseeable future, said investment experts. The tug-of-war is already underway -- shares of Excite@Home (Nasdaq: ATHM) fell Thursday after the company said it was foregoing near-term profits for long-term market share. The usually optimistic Merrill Lynch analyst Henry Blodget said he didn't 'see any positive catalysts for the stock.'
And in recent weeks, companies with no roadmap to earnings suffered the most (see chart). Shares of companies like CDNow (Nasdaq: CDNW), DrKoop.com (Nasdaq: KOOP) and Webvan (Nasdaq: WBVN) have been decimated.
As investors shun promising ideas for real results, dot-coms will have to generate cash instead of running back to the market for a quick-fix stock offering. To determine the long-term winners, investors will have to scrutinize business models and look for balance between growth and profitability.
Growth vs. profit
It's a fine line to walk between generating profits and growing. Excite@Home was panned by some analysts because it chose international expansion over immediate profits. The problem? Excite@Home has been profitable and has a track record. The market is more forgiving with promising newcomers.
'Companies that have been around for a while should have profits, but newcomers should be allowed time to build market share,' said Abhishek Gami, analyst for William Blair & Co.
Gami said he would allow business-to-consumer e-commerce companies about 12 to 18 months to become profitable. In the business-to-business space, a company should have as much as two to three years to turn a profit. In B2B, there are only a handful of competitors and a lot of market share to grab. With a portal, he wouldn't look at anything that didn't plan on earnings within 12 to 18 months.
About.com (Nasdaq: BOUT), which is far below its 52-week high of 105 13/16, is caught in the middle.
'Investors are looking at the total market, not individual companies,' said About.com CEO Scott Kurnit. 'They are looking at stock charts, and bringing the company down to at least 50 percent below its 52-week high, without regard for when the company reached its peak, or why.'
Kurnit is hoping a path to profits and strong third and fourth quarters will give About.com a boost. But his company is still in danger: Kurnit said About.com won’t be profitable for another 20 months.
The profit club
About.com is on the outside looking into a club that includes Yahoo! Inc. (Nasdaq: YHOO), eBay (Nasdaq: EBAY), America Online (NYSE: AOL), RealNetworks (Nasdaq: RNWK), Lycos (Nasdaq: LCOS) and Go2Net (Nasdaq: GNET). Inktomi (Nasdaq: INKT) and CNet (Nasdaq: CNET) are the latest members to the profitable dot-com club.
'The end game is, everyone will ask about profitability for every Net stock,' said Go2Net president John Keister. 'In 1997, people were talking about investing in earnings multiples for 2000, and now its 2002. People keep pushing it out.
'Smart investors, and institutional investors may not be satisfied with this anymore. Everyone has to trade on a multiple of earnings and revenue growth,' said Keister.
Leadership counts too
Leadership also counts for a lot. Chuck Hill, director of research at earnings tracking firm First Call, noted that profitable companies such as Yahoo, Go2Net, RealNetworks, AOL and Lycos have held up better than others, but said it doesn't have much to do with earnings. Hill said those companies are seen as industry leaders, which will survive. 'Even these companies are selling at multiples that are questionable,' he added.
'When a new company comes along, it's valued as a concept. Then there's a correction, and those that survive go on to be a good growth stock,' Hill said.
http://news.cnet.com/Patience-to-Earnings-ratio-wears-thin-for-dot-coms/2100-12_3-262272.html
Showing posts with label business valuations. Show all posts
Showing posts with label business valuations. Show all posts
Friday 13 November 2009
Valuation Methodologies
Despite their widespread usage, only limited theory is available to guide the application of multiples. With a few exceptions, the finance and accounting literature contain inadequate support on how or why certain multiples or comparable firms should be chosen in specific contexts. Compared to the DCF and RIV approach, standard textbooks on valuation devote little space to discussing the multiples valuation method.
Valuation Methodologies
This note provides an overview of the wide range of methodologies employed by Davy analysts when valuing shares.
One approach used is to apply average valuation multiples derived over multi-year periods, primarily with a view to smoothing cyclical effects.
Share-based multiples include:
Historic and forward price/earnings (P/E) ratios, based on normalised earnings before goodwill amortisation
Historic and forward price/cash-earnings (pre-depreciation) ratios
Price to net asset value per share
Dividend yields
Enterprise-based valuation multiples include:
Historic and forward earnings before depreciation, interest, tax, depreciation or amortisation (EBITDA) ratios; EBITDAR ratios are used where rental/lease charges (R) are material
Historic and forward EBITA ratios
Historic and forward operating cash-flow ratios
Enterprise value (EV)/sales ratios
EV/invested capital ratios
As enterprise values include net financial liabilities and minority interests, these are then deducted to arrive at the residual equity value.
Cyclical considerations
In the case of average earnings multiples, cognisance is given to the stage of the relevant industry cycle, as it may not be appropriate to apply average multiples towards the peak or trough of a cycle. In such cases, earnings multiples prevailing at the corresponding stages of previous cycles may be used.
Asset-based valuations
In the case of asset-based valuations, reported net assets generally provide a floor to a company's valuation. In many cases, however, company accounts can understate the underlying economic value of a company's assets, and a ratio such as return on invested capital to weighted average cost of capital (ROIC/WACC) may provide a more appropriate indicator of the book value multiple.
Company comparisons
The ratings of similar companies may be taken into account in valuing shares, as indeed may average ratings for particular industry sectors. Such ratings are commonly used in analysts' sum-of-the-parts (SOTP) valuations.
Cash-flow based valuation
In discounted cash-flow (DCF) models a company's forecast future free cash-flows are discounted by its weighted WACC. Due to the uncertainties involved in forecasting long-term cash-flows, analysts use a number of different DCF models.
Other valuation techniques
In some instances, other valuation metrics may be used. For instance, enterprise value per tonne of installed capacity may be used in capital-intensive sectors or in the earlier stages of a company's development.
http://www.davy.ie/Generic?page=valuationmethodologies
Valuation Methodologies
This note provides an overview of the wide range of methodologies employed by Davy analysts when valuing shares.
One approach used is to apply average valuation multiples derived over multi-year periods, primarily with a view to smoothing cyclical effects.
Share-based multiples include:
Historic and forward price/earnings (P/E) ratios, based on normalised earnings before goodwill amortisation
Historic and forward price/cash-earnings (pre-depreciation) ratios
Price to net asset value per share
Dividend yields
Enterprise-based valuation multiples include:
Historic and forward earnings before depreciation, interest, tax, depreciation or amortisation (EBITDA) ratios; EBITDAR ratios are used where rental/lease charges (R) are material
Historic and forward EBITA ratios
Historic and forward operating cash-flow ratios
Enterprise value (EV)/sales ratios
EV/invested capital ratios
As enterprise values include net financial liabilities and minority interests, these are then deducted to arrive at the residual equity value.
Cyclical considerations
In the case of average earnings multiples, cognisance is given to the stage of the relevant industry cycle, as it may not be appropriate to apply average multiples towards the peak or trough of a cycle. In such cases, earnings multiples prevailing at the corresponding stages of previous cycles may be used.
Asset-based valuations
In the case of asset-based valuations, reported net assets generally provide a floor to a company's valuation. In many cases, however, company accounts can understate the underlying economic value of a company's assets, and a ratio such as return on invested capital to weighted average cost of capital (ROIC/WACC) may provide a more appropriate indicator of the book value multiple.
Company comparisons
The ratings of similar companies may be taken into account in valuing shares, as indeed may average ratings for particular industry sectors. Such ratings are commonly used in analysts' sum-of-the-parts (SOTP) valuations.
Cash-flow based valuation
In discounted cash-flow (DCF) models a company's forecast future free cash-flows are discounted by its weighted WACC. Due to the uncertainties involved in forecasting long-term cash-flows, analysts use a number of different DCF models.
Other valuation techniques
In some instances, other valuation metrics may be used. For instance, enterprise value per tonne of installed capacity may be used in capital-intensive sectors or in the earlier stages of a company's development.
http://www.davy.ie/Generic?page=valuationmethodologies
Demystifying Small Business Valuation
Demystifying Small Business Valuation
Valuing a business is based on return on your investment (ROI). The value of a Business for Sale does not need to be subjective and can be based on several attributes and industry best practices.
Approach to Business Valuation
Valuing businesses is of paramount importance to a small business. It is one of the several metrics used to ensure the business is growing and creating value for the owners. There are several approaches to valuing a business including:
• Revenue Multiples
Earnings Multiples (including EBITA and operating income)
• Multiple of Book Value
Multiple of a measured unit (Like Restaurant tables, hospital beds, subscribers and more)
Rules of thumb are used by business brokers to ascertain the price of a business and simplify the valuation process. However, one must be mindful that the values determined using “Rule of thumb” are simplifications and only an estimate of the true value of the business. The “Rule of thumb” approach is used as a staring point before conducting detailed due-diligence to ascertain the correct value. Some examples of “Rules of thumb” used in the industry are listed in Table 1 below:
Table 1: Rules of Thumb Valuation
Type of Business “Rule of Thumb” valuation
Book Stores 15% of annual sales + inventory
Coffee Shops 40% - 45% of annual sales + inventory
Food/Gourmet Shops 20% of annual sales + inventory
Gas Stations 15% - 25% of annual sales + equip/inventory
Restaurants (non-franchised) 30% - 45% of annual sales
Dry Cleaners 70% - 100% of annual sales
A common approach to valuing a business is to use earnings or sales multiples. In this case since the price it is derived from annual earnings or sales and it directly addresses a buyer’s motive of estimating the return on investment (ROI) on deals.
When using earnings multipliers, it is inappropriate to get the multiples from Real Estate or Stock Markets. Real Estate is historically priced at 8 to 10 times its net operating income (EBITA). Stock markets are typically priced at 12 to 20 times earnings. These multiples do not apply to small businesses as the risk premium associated with a small business is much higher than managing a building or a stock portfolio.
Therefore, the first step in using the earnings multiplier approach is to determine which earnings multiplier is to be used. For example, one could use the current earnings, next year’s earnings or last 5 years earnings averaged. Other factors to consider include determining the composition of earnings. Do we need to calculate earnings after owner’s pay and perks, interest expenses, depreciation and taxes? The preferred earnings to use are 'Earnings before Interest and Taxes’ (EBIT).
Normalized earnings are adjusted for cyclical ups and downs in the economy. They are also adjusted for unusual or one-time influences. For small businesses normalized earnings projections are quite useful.
Finally we need to determine the multiplier. The number picked for multiplier is based on risk and there usually are “Rules of Thumb” multiplier numbers depending on the industry.
Using a multiplier with annual sales is also a common approach. For example, the “Rule of thumb” for a coffee shop is 40% - 45% of annual sales + inventory.
Tangible and Intangible assets
A tangible asset is an asset that has a physical form such as land, buildings and machinery. Intangible assets are the opposite of tangible assets. Intangible assets include patents, trademarks, brand value etc. Tangible and intangible assets raise interesting questions when valuing a business.
Typically once the value of the business itself has been ascertained, we need to factor in a value for Tangible and Intangible assets. These assets usually have a value separate from the business. One way to determine if an asset should be included as a tangible/intangible asset or included in the price for the business is to determine if the asset was used to generate the projected earnings. If the asset was used to generate earnings it should be included as a part of the multiple derived price of the business.
Factoring in tangible assets separately is especially true for businesses that own land and buildings, as these assets can be sold in the market even if the business failed. Therefore the best way to treat tangible/intangible asset is to separate them from the business and then add them back to the multiple derived value of the business. Obviously during the valuation period, asserts should not be counted twice. For example if the building has been factored out as a tangible and intangible asset, then rent for the premises must be subtracted from the business earnings. Similarly inventory impacts the business value. Typically inventory is valued at cost and treated as a tangible asset.
Earnings Multiples
After the value of tangible and intangible assets is determined we need to determine the value of the business using the correct multiples. Multiples used are very specific to a business and location of the business but broadly speaking it can be between 2 to 5 times normalized EBIT (Earnings before Interest and Taxes). The business can be worth more if it is has distinctive attributes that make it very attractive. To the buyer, 2 to 5 times earnings represent getting back their investment in the business in 2 to 5 years from profits a projected annual return of 20% to 50%.
Eventually the right multiple is the amount the buyer is willing to pay for the business. A business can demand higher multiples by clearly defining a case to increase earnings over time.
Disadvantages and caveats
Based on the content covered earlier, you may wonder how one can be certain the business valuation is perfect for the business buyer and seller. In reality there is no perfect price and techniques described in the earlier sections are just guidelines to derive an acceptable price.
The multiplier approach discussed does not provide sufficient information to assess the uniqueness of the business, such as management depth, customer relationships, industry trends, reputation, location, competition, capital structure and other information unique to the business. Further, two businesses of the same type and same revenue can have different cash flows.
The rules for evaluating a business are more of guidance then a hard and fast rule. They should be thought of as a starting point which can be further refined by factors specifically impacting the business. Proper evaluation will go beyond calculations based on multiples and tangible/intangible asset values. It requires complete business, marketing and financial due-diligence. However the approach describes in this article can play a key role in determining a starting value of your business.
Sites such as http://www.buysellbusiness.org allow entrepreneurs to do deals by buying and selling businesses and partnering. When researching businesses for deals, these guidelines can play an important role in quickly calculating the intrinsic value of a business.
http://www.buysellbusiness.org/BusinessTools/BizValuations.aspx
Valuing a business is based on return on your investment (ROI). The value of a Business for Sale does not need to be subjective and can be based on several attributes and industry best practices.
Approach to Business Valuation
Valuing businesses is of paramount importance to a small business. It is one of the several metrics used to ensure the business is growing and creating value for the owners. There are several approaches to valuing a business including:
• Revenue Multiples
Earnings Multiples (including EBITA and operating income)
• Multiple of Book Value
Multiple of a measured unit (Like Restaurant tables, hospital beds, subscribers and more)
Rules of thumb are used by business brokers to ascertain the price of a business and simplify the valuation process. However, one must be mindful that the values determined using “Rule of thumb” are simplifications and only an estimate of the true value of the business. The “Rule of thumb” approach is used as a staring point before conducting detailed due-diligence to ascertain the correct value. Some examples of “Rules of thumb” used in the industry are listed in Table 1 below:
Table 1: Rules of Thumb Valuation
Type of Business “Rule of Thumb” valuation
Book Stores 15% of annual sales + inventory
Coffee Shops 40% - 45% of annual sales + inventory
Food/Gourmet Shops 20% of annual sales + inventory
Gas Stations 15% - 25% of annual sales + equip/inventory
Restaurants (non-franchised) 30% - 45% of annual sales
Dry Cleaners 70% - 100% of annual sales
A common approach to valuing a business is to use earnings or sales multiples. In this case since the price it is derived from annual earnings or sales and it directly addresses a buyer’s motive of estimating the return on investment (ROI) on deals.
When using earnings multipliers, it is inappropriate to get the multiples from Real Estate or Stock Markets. Real Estate is historically priced at 8 to 10 times its net operating income (EBITA). Stock markets are typically priced at 12 to 20 times earnings. These multiples do not apply to small businesses as the risk premium associated with a small business is much higher than managing a building or a stock portfolio.
Therefore, the first step in using the earnings multiplier approach is to determine which earnings multiplier is to be used. For example, one could use the current earnings, next year’s earnings or last 5 years earnings averaged. Other factors to consider include determining the composition of earnings. Do we need to calculate earnings after owner’s pay and perks, interest expenses, depreciation and taxes? The preferred earnings to use are 'Earnings before Interest and Taxes’ (EBIT).
Normalized earnings are adjusted for cyclical ups and downs in the economy. They are also adjusted for unusual or one-time influences. For small businesses normalized earnings projections are quite useful.
Finally we need to determine the multiplier. The number picked for multiplier is based on risk and there usually are “Rules of Thumb” multiplier numbers depending on the industry.
Using a multiplier with annual sales is also a common approach. For example, the “Rule of thumb” for a coffee shop is 40% - 45% of annual sales + inventory.
Tangible and Intangible assets
A tangible asset is an asset that has a physical form such as land, buildings and machinery. Intangible assets are the opposite of tangible assets. Intangible assets include patents, trademarks, brand value etc. Tangible and intangible assets raise interesting questions when valuing a business.
Typically once the value of the business itself has been ascertained, we need to factor in a value for Tangible and Intangible assets. These assets usually have a value separate from the business. One way to determine if an asset should be included as a tangible/intangible asset or included in the price for the business is to determine if the asset was used to generate the projected earnings. If the asset was used to generate earnings it should be included as a part of the multiple derived price of the business.
Factoring in tangible assets separately is especially true for businesses that own land and buildings, as these assets can be sold in the market even if the business failed. Therefore the best way to treat tangible/intangible asset is to separate them from the business and then add them back to the multiple derived value of the business. Obviously during the valuation period, asserts should not be counted twice. For example if the building has been factored out as a tangible and intangible asset, then rent for the premises must be subtracted from the business earnings. Similarly inventory impacts the business value. Typically inventory is valued at cost and treated as a tangible asset.
Earnings Multiples
After the value of tangible and intangible assets is determined we need to determine the value of the business using the correct multiples. Multiples used are very specific to a business and location of the business but broadly speaking it can be between 2 to 5 times normalized EBIT (Earnings before Interest and Taxes). The business can be worth more if it is has distinctive attributes that make it very attractive. To the buyer, 2 to 5 times earnings represent getting back their investment in the business in 2 to 5 years from profits a projected annual return of 20% to 50%.
Eventually the right multiple is the amount the buyer is willing to pay for the business. A business can demand higher multiples by clearly defining a case to increase earnings over time.
Disadvantages and caveats
Based on the content covered earlier, you may wonder how one can be certain the business valuation is perfect for the business buyer and seller. In reality there is no perfect price and techniques described in the earlier sections are just guidelines to derive an acceptable price.
The multiplier approach discussed does not provide sufficient information to assess the uniqueness of the business, such as management depth, customer relationships, industry trends, reputation, location, competition, capital structure and other information unique to the business. Further, two businesses of the same type and same revenue can have different cash flows.
The rules for evaluating a business are more of guidance then a hard and fast rule. They should be thought of as a starting point which can be further refined by factors specifically impacting the business. Proper evaluation will go beyond calculations based on multiples and tangible/intangible asset values. It requires complete business, marketing and financial due-diligence. However the approach describes in this article can play a key role in determining a starting value of your business.
Sites such as http://www.buysellbusiness.org allow entrepreneurs to do deals by buying and selling businesses and partnering. When researching businesses for deals, these guidelines can play an important role in quickly calculating the intrinsic value of a business.
http://www.buysellbusiness.org/BusinessTools/BizValuations.aspx
Valuation: What's it worth?
What's it worth?
Although there are several formulas you can use, there are no black-and-white answers on valuation techniques.
It’s important to conduct your own research, then get independent advice from a business valuer or broker. Here are four of the most commonly used valuation methods.
Method 1: Asset valuation
Method 2: Capitalised future earnings
Method 3: Earnings multiple
Method 4: Comparable sales
Method 1: Asset valuation
This approach determines the value of a business by adding up the value of its assets and subtracting liabilities. It tells you what the business would be worth if it were closed down today and its assets sold off, but it doesn’t take into account the ability of those assets to generate revenue in the future. For that reason, it may understate the true value of the business.
How it works
1.Add up the value of all the assets such as cash, stock, plant and equipment and receivables.
2.Add up liabilities, such as any bank debts and payments due.
3.Subtract the business’ liabilities from its assets to get the net asset value.
Example
Richard wants to buy a manufacturing business. Here’s an extract from the business’ balance sheet.
With assets of $300,000 and liabilities of $200,000, the net asset value of the business is $100,000.
What about goodwill?
This method doesn’t include a value for goodwill or the right to earn future profits, so it may understate the true value of a business. Goodwill is the difference between the true value of a business and the value of its net assets. It can be crucial to the value of retail and service-based businesses.
For example, when you are valuing a business such as a hairdressing salon, where the standard of service, location and reputation are important, the value of any goodwill would have to be added to net assets to get a valuation.
You need to consider whether goodwill can be transferred when you buy the business. While goodwill can come from physical features such as location, it can also arise from personal factors, such as the owner’s reputation or their relationships with customers or suppliers, which may not be transferable.
And if the business is underperforming and there is no goodwill attached to it, then using the net assets valuation method could be an accurate way of determining its value.
Method 2: Capitalised future earnings
When you buy a business, you’re not only buying its assets. You’re also buying the right to all of the profits that business might generate. Different valuation methods try to capture that.
Capitalising future earnings is the most common method used to value small businesses. The method looks at the rate of return on investment (ROI) that you can expect to get from the business.
How it works
1.Work out the average net profit of the business over the last three years using its profit-and-loss statements. You’ll need to adjust the profit for any one-off expenses or other irregular items each year.
2.Decide the annual rate of return that you’re looking for as a business owner (for example, 20%). There are no hard and fast rules about what number you should choose, except that the higher the risk, the higher your return should be. A good starting point is to compare the business with other investment opportunities — everything from safe havens like term deposits, to riskier investments like shares. You can also look at the rate of return that similar businesses in the same industry achieve.
3.Divide net profits by the rate of return to determine the value of the business, then multiply by 100.
Example
David is looking at buying a bakery business with average net profits of $100,000 per annum after adjustments. David wants an annual rate of return of 20%. The capitalised earnings valuation is:
Method 3: Earnings multiple
If you invest in shares, you might already be familiar with this method, since it’s often used to assess the value of companies whose shares are traded on a stock exchange and therefore reflect market expectations. But it can be used to value unlisted businesses.
Its big advantage is its simplicity. The difficulty lies in deciding which multiple to use.
How it works
Simply multiply the business’ earnings before interest and tax (EBIT) by your selected multiple. For example, you might value the business at twice its annual earnings — so a business with an EBIT of $200,000 might be valued at $400,000.
The multiple you choose will depend on the industry and the growth potential of the business. A service-based business might be valued at as little as one year’s earnings, while an established business with sustainable profits might sell for as much as six times earnings. (Listed companies trade at much higher multiples, because their size and liquidity makes them less risky investments.)
This method can be useful for valuing a business where there are regular sales of similar businesses to help you determine an objective earnings multiple. A business broker should be able to tell you this.
Method 4: Comparable sales
Whatever other valuation method you use, you should also look at prices for recent sales of similar businesses. Like buying a house, it makes sense to know what is happening in the market in which you’re interested.
Speak to a few business brokers and gauge their feeling about the business’ value. They might know what similar operations are selling for and how the market is placed at that particular time. Check business-for-sale listings in relevant industry magazines, newspapers or websites.
Tools and templates
Buying a business checklist
Important information
As this advice has been prepared without considering your objectives, financial situation or needs, you should, before acting on the advice, consider its appropriateness to your circumstances. All products mentioned on this web page are issued by the Commonwealth Bank of Australia; view our Financial Services Guide (PDF 59kb).
http://www.commbank.com.au/business/betterbusiness/buying-a-business/whats-it-worth/
Although there are several formulas you can use, there are no black-and-white answers on valuation techniques.
It’s important to conduct your own research, then get independent advice from a business valuer or broker. Here are four of the most commonly used valuation methods.
Method 1: Asset valuation
Method 2: Capitalised future earnings
Method 3: Earnings multiple
Method 4: Comparable sales
Method 1: Asset valuation
This approach determines the value of a business by adding up the value of its assets and subtracting liabilities. It tells you what the business would be worth if it were closed down today and its assets sold off, but it doesn’t take into account the ability of those assets to generate revenue in the future. For that reason, it may understate the true value of the business.
How it works
1.Add up the value of all the assets such as cash, stock, plant and equipment and receivables.
2.Add up liabilities, such as any bank debts and payments due.
3.Subtract the business’ liabilities from its assets to get the net asset value.
Example
Richard wants to buy a manufacturing business. Here’s an extract from the business’ balance sheet.
With assets of $300,000 and liabilities of $200,000, the net asset value of the business is $100,000.
What about goodwill?
This method doesn’t include a value for goodwill or the right to earn future profits, so it may understate the true value of a business. Goodwill is the difference between the true value of a business and the value of its net assets. It can be crucial to the value of retail and service-based businesses.
For example, when you are valuing a business such as a hairdressing salon, where the standard of service, location and reputation are important, the value of any goodwill would have to be added to net assets to get a valuation.
You need to consider whether goodwill can be transferred when you buy the business. While goodwill can come from physical features such as location, it can also arise from personal factors, such as the owner’s reputation or their relationships with customers or suppliers, which may not be transferable.
And if the business is underperforming and there is no goodwill attached to it, then using the net assets valuation method could be an accurate way of determining its value.
Method 2: Capitalised future earnings
When you buy a business, you’re not only buying its assets. You’re also buying the right to all of the profits that business might generate. Different valuation methods try to capture that.
Capitalising future earnings is the most common method used to value small businesses. The method looks at the rate of return on investment (ROI) that you can expect to get from the business.
How it works
1.Work out the average net profit of the business over the last three years using its profit-and-loss statements. You’ll need to adjust the profit for any one-off expenses or other irregular items each year.
2.Decide the annual rate of return that you’re looking for as a business owner (for example, 20%). There are no hard and fast rules about what number you should choose, except that the higher the risk, the higher your return should be. A good starting point is to compare the business with other investment opportunities — everything from safe havens like term deposits, to riskier investments like shares. You can also look at the rate of return that similar businesses in the same industry achieve.
3.Divide net profits by the rate of return to determine the value of the business, then multiply by 100.
Example
David is looking at buying a bakery business with average net profits of $100,000 per annum after adjustments. David wants an annual rate of return of 20%. The capitalised earnings valuation is:
Method 3: Earnings multiple
If you invest in shares, you might already be familiar with this method, since it’s often used to assess the value of companies whose shares are traded on a stock exchange and therefore reflect market expectations. But it can be used to value unlisted businesses.
Its big advantage is its simplicity. The difficulty lies in deciding which multiple to use.
How it works
Simply multiply the business’ earnings before interest and tax (EBIT) by your selected multiple. For example, you might value the business at twice its annual earnings — so a business with an EBIT of $200,000 might be valued at $400,000.
The multiple you choose will depend on the industry and the growth potential of the business. A service-based business might be valued at as little as one year’s earnings, while an established business with sustainable profits might sell for as much as six times earnings. (Listed companies trade at much higher multiples, because their size and liquidity makes them less risky investments.)
This method can be useful for valuing a business where there are regular sales of similar businesses to help you determine an objective earnings multiple. A business broker should be able to tell you this.
Method 4: Comparable sales
Whatever other valuation method you use, you should also look at prices for recent sales of similar businesses. Like buying a house, it makes sense to know what is happening in the market in which you’re interested.
Speak to a few business brokers and gauge their feeling about the business’ value. They might know what similar operations are selling for and how the market is placed at that particular time. Check business-for-sale listings in relevant industry magazines, newspapers or websites.
Tools and templates
Buying a business checklist
Important information
As this advice has been prepared without considering your objectives, financial situation or needs, you should, before acting on the advice, consider its appropriateness to your circumstances. All products mentioned on this web page are issued by the Commonwealth Bank of Australia; view our Financial Services Guide (PDF 59kb).
http://www.commbank.com.au/business/betterbusiness/buying-a-business/whats-it-worth/
Thursday 12 November 2009
How is a P/E multiple used?
The Price/Earnings Multiple Enigma
If the Price to Earnings Multiple (P/E) were to be judged by usage, it wins hands down compared to any other valuation metric. It is easy to compute, can be applied across companies and across sectors, with a few exceptions. What is this ratio, how is it computed, and how to use it are questions to which you will find answers in this section.
What is a P/E multiple?
The P/E multiple is the premium that the market is willing to pay on the earnings per share of a company, based on its future growth. The ratio is most often used to conclude whether a stock is undervalued or overvalued. The P/E is calculated by dividing the current market price of a company's stock by the last reported full-year earnings per share (EPS). In effect, the ratio uses the company's earnings as a guide to value it. The P/E thus computed is also known as the trailing or historical P/E since it uses the trailing (historical) EPS in its calculations. With the advent of quarterly results, it is also possible to compute P/E, based on the earnings of the latest four quarters’ EPS. This is known as trailing twelve months P/E.
A variant of the P/E - called the forward P/E - has also been developed wherein the current market price of the stock is divided by the expected future EPS. The attempt to study P/E ratios in this manner reflects the effort to factor in the expected growth of a company.
Since stock market valuations factor in the future expectations of the market, a P/E multiple computed using historical earnings can at best be of academic value since it does not factor in the future growth in earnings. It fails to capture events that may have happened after the earnings date. For example, suppose a merger happens after the earnings have been declared, a P/E multiple based on the historical P/E will fail to capture this event in the EPS whereas the price would reflect it, creating a distortion.
The forward P/E is popularly used to find out if the premium the market is willing to pay on the earnings is line with the growth expectations. For example, the market price of Stock A is Rs 1,000, with a P/E multiple of 30 based on historical earnings. Assuming an earnings growth of 50%, the one year forward P/E changes to 20, which means the market is willing to pay 30 times its historical earnings and 20 times its one-year forward earnings.
For an investor it makes much more sense to look at the forward P/E for taking an investment decision. Each investor would have his or her own expectations regarding the future earnings growth. To that extent the forward P/E for a particular stock will vary from investor to investor.
How is a P/E multiple used?
P/E multiples reflect collective investor perception regarding a company's future. This perception is a function of various factors, like industry growth prospects, company’s position in industry, its growth plans, quantum change expected in sales or profit growth, quality of management, and other macroeconomic factors like interest rates and inflation.
Is a stock trading at a P/E of 30 more expensive than a stock trading at a P/E of 60? Such a wide variation in P/E multiples can be owing to a few reasons. If the companies are in the same industry, it could be that the company with a high P/E may be one with superior size and financials, with better prospects or even better management. The market expects this stock to outperform its peers. If they are from different industries, it could also be due to different growth prospects. For example, an energy utility will have a more sedate earnings profile than say a software company.
Besides different expectations regarding future earnings growth, some of the difference in P/E can also be attributed to the disclosures made by the management to their shareholders. Hence, qualitative factors like transparency, quality of management also impact a stock's P/E.
Stock prices, in isolation do not give any indication whether the stock is undervalued or overvalued. They have to be viewed along with the company's future prospects to arrive at any conclusion. Generally, higher the expected growth in a company's earnings, higher is the P/E multiple that it attracts in the market. The time period used for P/E calculations depends on the investment horizon of the investor and would be different for each investor. However, P/E multiples cannot be applied to loss making companies since they do not have any earnings.
Price to Earnings Growth Multiple (PEG)
The PEG multiple takes the P/E analysis to the next stage. Since P/E ratios are computed based on historic earnings, they project an inaccurate picture of the future. The PEG multiple uses expected growth in earnings, to give investors additional information. The PEG divides the historical P/E ratio by the compounded annual growth rate of future earnings. Generally, the compounded earnings growth is calculated using the forecasted earnings for the next two-three years.
For example, if a company is quoting at a P/E of 60 based on historic earnings and the compounded annual growth rate of its earnings for the next three years is 20 per cent, then its PEG is 3.
The lower the PEG, the more attractive the stock becomes as an investment proposition. It is obviously more appealing to buy a stock on a P/E of 20 whose earnings are growing at 50 per cent than to buy a stock on a multiple of 50 whose earnings are growing at 20 per cent. As a thumb rule, stocks quoting at a PEG multiple below 0.5 are considered to be undervalued, 1 to be fairly valued, and 2 to be overvalued.
http://www.hdfcsec.com/KnowledgeCenter/Story.aspx?ArticleID=8153321b-8faa-4429-abba-bbfe5f29e77d
If the Price to Earnings Multiple (P/E) were to be judged by usage, it wins hands down compared to any other valuation metric. It is easy to compute, can be applied across companies and across sectors, with a few exceptions. What is this ratio, how is it computed, and how to use it are questions to which you will find answers in this section.
What is a P/E multiple?
The P/E multiple is the premium that the market is willing to pay on the earnings per share of a company, based on its future growth. The ratio is most often used to conclude whether a stock is undervalued or overvalued. The P/E is calculated by dividing the current market price of a company's stock by the last reported full-year earnings per share (EPS). In effect, the ratio uses the company's earnings as a guide to value it. The P/E thus computed is also known as the trailing or historical P/E since it uses the trailing (historical) EPS in its calculations. With the advent of quarterly results, it is also possible to compute P/E, based on the earnings of the latest four quarters’ EPS. This is known as trailing twelve months P/E.
A variant of the P/E - called the forward P/E - has also been developed wherein the current market price of the stock is divided by the expected future EPS. The attempt to study P/E ratios in this manner reflects the effort to factor in the expected growth of a company.
Since stock market valuations factor in the future expectations of the market, a P/E multiple computed using historical earnings can at best be of academic value since it does not factor in the future growth in earnings. It fails to capture events that may have happened after the earnings date. For example, suppose a merger happens after the earnings have been declared, a P/E multiple based on the historical P/E will fail to capture this event in the EPS whereas the price would reflect it, creating a distortion.
The forward P/E is popularly used to find out if the premium the market is willing to pay on the earnings is line with the growth expectations. For example, the market price of Stock A is Rs 1,000, with a P/E multiple of 30 based on historical earnings. Assuming an earnings growth of 50%, the one year forward P/E changes to 20, which means the market is willing to pay 30 times its historical earnings and 20 times its one-year forward earnings.
For an investor it makes much more sense to look at the forward P/E for taking an investment decision. Each investor would have his or her own expectations regarding the future earnings growth. To that extent the forward P/E for a particular stock will vary from investor to investor.
How is a P/E multiple used?
P/E multiples reflect collective investor perception regarding a company's future. This perception is a function of various factors, like industry growth prospects, company’s position in industry, its growth plans, quantum change expected in sales or profit growth, quality of management, and other macroeconomic factors like interest rates and inflation.
Is a stock trading at a P/E of 30 more expensive than a stock trading at a P/E of 60? Such a wide variation in P/E multiples can be owing to a few reasons. If the companies are in the same industry, it could be that the company with a high P/E may be one with superior size and financials, with better prospects or even better management. The market expects this stock to outperform its peers. If they are from different industries, it could also be due to different growth prospects. For example, an energy utility will have a more sedate earnings profile than say a software company.
Besides different expectations regarding future earnings growth, some of the difference in P/E can also be attributed to the disclosures made by the management to their shareholders. Hence, qualitative factors like transparency, quality of management also impact a stock's P/E.
Stock prices, in isolation do not give any indication whether the stock is undervalued or overvalued. They have to be viewed along with the company's future prospects to arrive at any conclusion. Generally, higher the expected growth in a company's earnings, higher is the P/E multiple that it attracts in the market. The time period used for P/E calculations depends on the investment horizon of the investor and would be different for each investor. However, P/E multiples cannot be applied to loss making companies since they do not have any earnings.
Price to Earnings Growth Multiple (PEG)
The PEG multiple takes the P/E analysis to the next stage. Since P/E ratios are computed based on historic earnings, they project an inaccurate picture of the future. The PEG multiple uses expected growth in earnings, to give investors additional information. The PEG divides the historical P/E ratio by the compounded annual growth rate of future earnings. Generally, the compounded earnings growth is calculated using the forecasted earnings for the next two-three years.
For example, if a company is quoting at a P/E of 60 based on historic earnings and the compounded annual growth rate of its earnings for the next three years is 20 per cent, then its PEG is 3.
The lower the PEG, the more attractive the stock becomes as an investment proposition. It is obviously more appealing to buy a stock on a P/E of 20 whose earnings are growing at 50 per cent than to buy a stock on a multiple of 50 whose earnings are growing at 20 per cent. As a thumb rule, stocks quoting at a PEG multiple below 0.5 are considered to be undervalued, 1 to be fairly valued, and 2 to be overvalued.
http://www.hdfcsec.com/KnowledgeCenter/Story.aspx?ArticleID=8153321b-8faa-4429-abba-bbfe5f29e77d
Business valuation with price earnings multiples
Business valuation with price earnings multiples
Tuesday, 12 December 2006 02:45 Anton Joseph
E-mail | Print | Tags: valuation | business sale/purchase | ip revenue | strategy
When it comes to selling or buying a business the sale price is the greatest obstacle and point of disagreement in many transactions. If there is a reasonable and easily understandable way of determining the value of the business the parties can quickly progress more than half way through the sale process. Although it is said that the right tools must be used to value businesses, no simple method suits all types of businesses. Instead, there are several financial and non-financial performance indicators that are commonly used by businesses to monitor their progress. Some are used to measure profitability whilst others are used to test liquidity.
Financial indicators are normally measured by using ratios calculated using numerical values appearing in the profit and loss account or the balance sheet. Since the indicators are snapshot calculations based on historical figures (figures for the past year), there is an understandable reluctance to always rely on them. This is especially so when a small business is examined for its value for sale.
A prudent business seller or buyer can use financial indicators (such as industry conventions, multiples and ratios) as part of a toolkit to negotiate an acceptable business sale price. One indicator is a price earnings multiple. Elsewhere we have examined business valuation with EBIT multiples.
PE multiple or PE ratio definition
A price earning multiple (PE multiple) is used mostly to estimate the performance of companies whose shares are traded in public and therefore reflect market expectation to a credible extent. The PE multiple of a share is also commonly called its "PE ratio", "earnings multiple", "multiple", "P/E", or "PE").
The PE multiple method, while unorthodox for small and medium-sized businesses, may provide a useful indicator of the value of a business for sale purposes.
Examples of use of PE multiples in Australian business
You can achieve better outcomes as a seller or buyer if you properly prepare for and anticipate positions that various interested parties might hold during the negotiation dance that takes place for a business sale, purchase, takeover, merger or acquisition. It is useful to study prior transactions and to keep a close watch on market developments. Here are recent examples illustrating the use of PE multiples in media commentary, research reports and takeover documents.
Wealth Creator Magazine in its Sep/Oct 2006 issue reviews "hot" stocks in the 2006-07 financial year. In its commentary it says John Fairfax Holdings Ltd (ASX code: FXJ) "...is currently trading on a price earnings of 16 x and provides a yield of 4.5% fully franked..." and Fosters Group Ltd (ASX code: FGL) "...is trading at a price earnings multiple of 15.6 x 2006 earnings, which we believe is reasonable earnings, reduced gearing and upside potential as the cycle improves."
Intersuisse Ltd in an investment research statement dated 24 August 2006 makes a buy recommendation about BHP Billiton (ASX code: BHP) concluding: "We believe the depth and quality of the company's earnings are such that the stock deserved to be placed on a higher price/earnings (p/e) multiple than the prospective p/e of 10.4 times for FY07 and 9.8 times for FY08 and that multiples of at least 12 to 14 times would be more appropriate."
In an Independent Expert's Report Grant Samuel & Associates Pty Ltd assesses the takeover bid by Rank Group Australia Pty Ltd for Burns, Philp & Company Ltd. Grant Samuel states (at its page 18):
"Capitalisation of earnings or cash flows is the most commonly used method for valuation of industrial businesses. This methodology is most appropriate for industrial businesses with a substantial operating history and a consistent earnings trend that is sufficiently stable to be indicative of ongoing earnings potential. This methodology is not particularly suitable for start-up businesses, businesses with an erratic earnings pattern or businesses that have unusual capital expenditure requirements. This methodology involves capitalising the earnings or cash flows of a business at a multiple that reflects the risks of the business and the stream of income that it generates. These multiples can be applied to a number of different earnings or cash flow measures including EBITDA, EBIT or net profit after tax. These are referred to respectively as EBITDA multiples, EBIT multiples and price earnings multiples. Price earnings multiples are commonly used in the context of the sharemarket. EBITDA and EBIT multiples are more commonly used in valuing whole businesses for acquisition purposes where gearing is in the control of the acquirer."
How to calculate the PE multiple for your business
The PE multiple method is the most commonly used earnings capitalisation methodology. It appears in the following two equations:
1.Total value of business = PE multiple x net profit after tax (NPAT)
2.Value per share = PE multiple x earnings per share
The above two equations can be used to provide some indication of the value of a business. First, using the second equation, dividing the market price of a share by the earnings per share you will be able to calculate the PE multiple for the business. Then by multiplying the PE multiple by NPAT a value for the business can be determined.
With a public company, assume the market value of a share of the company is $35 and the earnings per share is $5, then the PE multiple is 25 divided by 5 which is 7. If the NPAT is $110,000 then the value of the business is $110,000 multiplied by 7, which is $770,000.
As a first step in using the above method, one needs to find a listed company carrying on a business similar to the business of the company to be valued. Next, obtain a copy of the most recent financial statements published by the company, from which the NPAT and EPS of the company can be obtained. Now obtain the recent price quoted for the shares in the company from its Website or the ASX Website.
EPS is a measure of the amount of profit that can be attributed to ordinary shares in the company. If the financial statements of the company do not provide the EPS, it can be calculated by dividing NPAT (after deducting NPAT attributable to any outside equity interests, such as preference shares and any payments made to such outside equity interests) by the total number of ordinary shares on issue. The total number of shares on issue can be got from the balance sheet of the company.
If the PE multiple of the company selected is high it can mean that the shares of the company are overpriced and yet the market is expecting a high return in the future. This could be for several reasons, such as potential for growth in the overseas market or even a change of the CEO. Similarly the PE multiple could be low and the shares underpriced because the company selected is about to be brought under a strict regulatory regime by the Government or it has lost a crucial licence. What is suggested here is that the PE multiple calculated using a typical company in the industry may not totally reflect the situation of the business under review.
PE multiple caution
Since the PE multiple method of valuation is dependent on factors that are approximations, consideration of other relevant performance ratios is recommended, eg dividend per share, dividend yield, dividend cover, net tangible assets per share and cash flow per share.
Ultimately working out the PE multiple is a job for a specialist or professional. It is not a job for a lawyer. It is also not a job for a non-financial business executive who is not properly briefed. But it is useful for everyone to be aware of how the numbers are derived.
http://www.dilanchian.com.au/index.php?option=com_content&task=view&id=166&Itemid=148
Tuesday, 12 December 2006 02:45 Anton Joseph
E-mail | Print | Tags: valuation | business sale/purchase | ip revenue | strategy
When it comes to selling or buying a business the sale price is the greatest obstacle and point of disagreement in many transactions. If there is a reasonable and easily understandable way of determining the value of the business the parties can quickly progress more than half way through the sale process. Although it is said that the right tools must be used to value businesses, no simple method suits all types of businesses. Instead, there are several financial and non-financial performance indicators that are commonly used by businesses to monitor their progress. Some are used to measure profitability whilst others are used to test liquidity.
Financial indicators are normally measured by using ratios calculated using numerical values appearing in the profit and loss account or the balance sheet. Since the indicators are snapshot calculations based on historical figures (figures for the past year), there is an understandable reluctance to always rely on them. This is especially so when a small business is examined for its value for sale.
A prudent business seller or buyer can use financial indicators (such as industry conventions, multiples and ratios) as part of a toolkit to negotiate an acceptable business sale price. One indicator is a price earnings multiple. Elsewhere we have examined business valuation with EBIT multiples.
PE multiple or PE ratio definition
A price earning multiple (PE multiple) is used mostly to estimate the performance of companies whose shares are traded in public and therefore reflect market expectation to a credible extent. The PE multiple of a share is also commonly called its "PE ratio", "earnings multiple", "multiple", "P/E", or "PE").
The PE multiple method, while unorthodox for small and medium-sized businesses, may provide a useful indicator of the value of a business for sale purposes.
Examples of use of PE multiples in Australian business
You can achieve better outcomes as a seller or buyer if you properly prepare for and anticipate positions that various interested parties might hold during the negotiation dance that takes place for a business sale, purchase, takeover, merger or acquisition. It is useful to study prior transactions and to keep a close watch on market developments. Here are recent examples illustrating the use of PE multiples in media commentary, research reports and takeover documents.
Wealth Creator Magazine in its Sep/Oct 2006 issue reviews "hot" stocks in the 2006-07 financial year. In its commentary it says John Fairfax Holdings Ltd (ASX code: FXJ) "...is currently trading on a price earnings of 16 x and provides a yield of 4.5% fully franked..." and Fosters Group Ltd (ASX code: FGL) "...is trading at a price earnings multiple of 15.6 x 2006 earnings, which we believe is reasonable earnings, reduced gearing and upside potential as the cycle improves."
Intersuisse Ltd in an investment research statement dated 24 August 2006 makes a buy recommendation about BHP Billiton (ASX code: BHP) concluding: "We believe the depth and quality of the company's earnings are such that the stock deserved to be placed on a higher price/earnings (p/e) multiple than the prospective p/e of 10.4 times for FY07 and 9.8 times for FY08 and that multiples of at least 12 to 14 times would be more appropriate."
In an Independent Expert's Report Grant Samuel & Associates Pty Ltd assesses the takeover bid by Rank Group Australia Pty Ltd for Burns, Philp & Company Ltd. Grant Samuel states (at its page 18):
"Capitalisation of earnings or cash flows is the most commonly used method for valuation of industrial businesses. This methodology is most appropriate for industrial businesses with a substantial operating history and a consistent earnings trend that is sufficiently stable to be indicative of ongoing earnings potential. This methodology is not particularly suitable for start-up businesses, businesses with an erratic earnings pattern or businesses that have unusual capital expenditure requirements. This methodology involves capitalising the earnings or cash flows of a business at a multiple that reflects the risks of the business and the stream of income that it generates. These multiples can be applied to a number of different earnings or cash flow measures including EBITDA, EBIT or net profit after tax. These are referred to respectively as EBITDA multiples, EBIT multiples and price earnings multiples. Price earnings multiples are commonly used in the context of the sharemarket. EBITDA and EBIT multiples are more commonly used in valuing whole businesses for acquisition purposes where gearing is in the control of the acquirer."
How to calculate the PE multiple for your business
The PE multiple method is the most commonly used earnings capitalisation methodology. It appears in the following two equations:
1.Total value of business = PE multiple x net profit after tax (NPAT)
2.Value per share = PE multiple x earnings per share
The above two equations can be used to provide some indication of the value of a business. First, using the second equation, dividing the market price of a share by the earnings per share you will be able to calculate the PE multiple for the business. Then by multiplying the PE multiple by NPAT a value for the business can be determined.
With a public company, assume the market value of a share of the company is $35 and the earnings per share is $5, then the PE multiple is 25 divided by 5 which is 7. If the NPAT is $110,000 then the value of the business is $110,000 multiplied by 7, which is $770,000.
As a first step in using the above method, one needs to find a listed company carrying on a business similar to the business of the company to be valued. Next, obtain a copy of the most recent financial statements published by the company, from which the NPAT and EPS of the company can be obtained. Now obtain the recent price quoted for the shares in the company from its Website or the ASX Website.
EPS is a measure of the amount of profit that can be attributed to ordinary shares in the company. If the financial statements of the company do not provide the EPS, it can be calculated by dividing NPAT (after deducting NPAT attributable to any outside equity interests, such as preference shares and any payments made to such outside equity interests) by the total number of ordinary shares on issue. The total number of shares on issue can be got from the balance sheet of the company.
If the PE multiple of the company selected is high it can mean that the shares of the company are overpriced and yet the market is expecting a high return in the future. This could be for several reasons, such as potential for growth in the overseas market or even a change of the CEO. Similarly the PE multiple could be low and the shares underpriced because the company selected is about to be brought under a strict regulatory regime by the Government or it has lost a crucial licence. What is suggested here is that the PE multiple calculated using a typical company in the industry may not totally reflect the situation of the business under review.
PE multiple caution
Since the PE multiple method of valuation is dependent on factors that are approximations, consideration of other relevant performance ratios is recommended, eg dividend per share, dividend yield, dividend cover, net tangible assets per share and cash flow per share.
Ultimately working out the PE multiple is a job for a specialist or professional. It is not a job for a lawyer. It is also not a job for a non-financial business executive who is not properly briefed. But it is useful for everyone to be aware of how the numbers are derived.
http://www.dilanchian.com.au/index.php?option=com_content&task=view&id=166&Itemid=148
Modern trading making earnings multiples obsolete
Modern trading making earnings multiples obsolete
by Grace Chen on May 19, 2008
Price to earnings multiples were once the basis of investment decisions. The analysis was simple: the return divided by the stock price should properly valuate a certain company. But with many companies all over the map in both PE and PEG ratios, investors are looking for other guidelines for evaluating an investment. Technical trading has all but taken over the short term trader, and it looks ready to conquer the long term as well.
Old value investors
Warren Buffett dominates the field of value investing. Rather than following the world’s hottest stocks, he looks for companies that are considerably undervalued, both by assets and what he believes the company is really worth. While he’s made a large fortune from his studies on value investing, the markets are seemingly turning out of his favor. Valuing a company is no longer as easy as looking for cheap assets, as many companies have little assets to back their valuations. Others trade at huge multiples of their earnings, while their competitors enjoy smaller ratios, and even others are destined to stay cheap forever due only to the nature of the business.
Case in point
It seems that many companies are selling for high premiums, even with little to back up their valuations. Take for example the internet stocks. Google sells for a PE ratio of 41 but a PEG of 1.02. While Google does sell for an extreme premium over its earnings, adjusted for growth Google is still in the buy range. Compare these statistics to the lesser rival Yahoo, which trades for a PE of 33 and a PEG of 2.8. Even prior to the failed Microsoft bid, Yahoo traded at a similar PE and PEG ratio; for the most part, it’s horribly overvalued.
Traditionally, you would think that the two valuations would come to meet each other in the middle. Google’s price would ultimately rise while Yahoo would shed a few points to come back to earth. Though this is what the rational person would think, it seems like Yahoo will forever enjoy being overpriced and Google will always be under priced. In fact, Google has never traded for a PEG ratio higher than 2. Yahoo has traded for both extremely high PE ratios and PEGs, though its data is somewhat skewed by the y2k internet bubble fiasco.
Has technical analysis beat out fundamentals?
It appears as though technical traders have finally won over the market. By looking at today’s measurements, Yahoo’s stock is kept afloat largely by technical support and resistance, while Google is much the same. The difference in trading techniques even from just 2004 to today would suggest that stocks are now traded more independently than ever. Rarely are stocks compared to reasonable value to their competitors by investors. The new age of trading is systematically making investors “one stock” types, those only willing to trade the ups and downs and day to day of a specific stock, rather than comparing it to its competition.
Investing at its roots has been crippled. The sustainability or profitability of future results are rarely calculated in many investors algorithms. Technical analysis has instead brought trading to a whole new level, where stocks are nearly as good as any other commodity. The earnings of a company no longer matter, nor do its assets, nor its valuation. The digits in the stock price are the few things that matter to most modern day traders; forget the business behind the ticker.
http://www.investortrip.com/modern-trading-making-earnings-multiples-obsolete/
Comment: Ohhhh!!!!!
by Grace Chen on May 19, 2008
Price to earnings multiples were once the basis of investment decisions. The analysis was simple: the return divided by the stock price should properly valuate a certain company. But with many companies all over the map in both PE and PEG ratios, investors are looking for other guidelines for evaluating an investment. Technical trading has all but taken over the short term trader, and it looks ready to conquer the long term as well.
Old value investors
Warren Buffett dominates the field of value investing. Rather than following the world’s hottest stocks, he looks for companies that are considerably undervalued, both by assets and what he believes the company is really worth. While he’s made a large fortune from his studies on value investing, the markets are seemingly turning out of his favor. Valuing a company is no longer as easy as looking for cheap assets, as many companies have little assets to back their valuations. Others trade at huge multiples of their earnings, while their competitors enjoy smaller ratios, and even others are destined to stay cheap forever due only to the nature of the business.
Case in point
It seems that many companies are selling for high premiums, even with little to back up their valuations. Take for example the internet stocks. Google sells for a PE ratio of 41 but a PEG of 1.02. While Google does sell for an extreme premium over its earnings, adjusted for growth Google is still in the buy range. Compare these statistics to the lesser rival Yahoo, which trades for a PE of 33 and a PEG of 2.8. Even prior to the failed Microsoft bid, Yahoo traded at a similar PE and PEG ratio; for the most part, it’s horribly overvalued.
Traditionally, you would think that the two valuations would come to meet each other in the middle. Google’s price would ultimately rise while Yahoo would shed a few points to come back to earth. Though this is what the rational person would think, it seems like Yahoo will forever enjoy being overpriced and Google will always be under priced. In fact, Google has never traded for a PEG ratio higher than 2. Yahoo has traded for both extremely high PE ratios and PEGs, though its data is somewhat skewed by the y2k internet bubble fiasco.
Has technical analysis beat out fundamentals?
It appears as though technical traders have finally won over the market. By looking at today’s measurements, Yahoo’s stock is kept afloat largely by technical support and resistance, while Google is much the same. The difference in trading techniques even from just 2004 to today would suggest that stocks are now traded more independently than ever. Rarely are stocks compared to reasonable value to their competitors by investors. The new age of trading is systematically making investors “one stock” types, those only willing to trade the ups and downs and day to day of a specific stock, rather than comparing it to its competition.
Investing at its roots has been crippled. The sustainability or profitability of future results are rarely calculated in many investors algorithms. Technical analysis has instead brought trading to a whole new level, where stocks are nearly as good as any other commodity. The earnings of a company no longer matter, nor do its assets, nor its valuation. The digits in the stock price are the few things that matter to most modern day traders; forget the business behind the ticker.
http://www.investortrip.com/modern-trading-making-earnings-multiples-obsolete/
Comment: Ohhhh!!!!!
A Crash Course on Earnings Multiples
A Crash Course on Earnings Multiples
As a trusted business advisor you’ve probably heard former business owners telling people that they sold their business for “six times earnings.” As investment bankers, the first question we hear from prospective clients is “Can I get the same multiple if I sell my business?” The answer is an unequivocal "it depends." It depends on a number of things, but first and foremost, it depends on how you define “earnings”.
As all investment bankers and sellers know, “Cash is King.” After all, cash removes the seller’s risk in the transaction. However, when a buyer pays cash for a business, that buyer wants to know exactly how much the business is earning.
Let’s start with what seems to be a pretty basic concept: earnings.
The Definitions of Earnings
There are several definitions of earnings; each is potentially different from the other depending on the type of company and the way its owner runs the company. Typical measures of earnings include:
§ Net Operating Income: This is sales less the cost of goods sold and operating expenses.
§ Pre-tax Income: This is net operating income plus non-operating income (like interest on notes, etc.) less non-operating expenses (like one-time, non-recurring expenses).
§ After-tax Income: Pre-tax income, less all company (but not individual) taxes.
§ EBIT: This stands for earnings before interest and taxes.
§ EBITDA: This stands for earnings before interest, taxes, depreciation and amortization
Add to these measures, the need to “adjust" earnings by deducting capital expenditures, and adding back excess rents, excessive salary and bonuses paid to the owner and his or her family. The result is something called:
Owner’s Discretionary Cash Flow or True Cash Flow: This is the amount of pre-tax money distributed to owners via salary, bonus, distributions from the company such as S-distributions, and rental payments in excess of fair market rental value of the equipment or building used in the business. This provides buyers with the most accurate indicator of how much “cash” a company can actually produce and is often the most meaningful indicator of value.
Which brings us back to our original question: Is it realistic for a business owner to expect a six times multiple when he sells his business? There is no one right or wrong answer to this question.
To show you how tricky this can be, let’s look at a former client of ours. His business was not doing well. He had revenues of approximately $7 million but, even using the most generous definition of earnings, the company was not earning more that about $100,000 per year. We ultimately sold the company to a buyer of distressed companies who paid book value for its assets or about $2 million. Despite this low value, our client was extremely happy because his business sold for 20 times earnings! In this case the buyer was buying assets, not earnings, so an earning multiple wasn’t even appropriate.
To determine which measure of earnings is appropriate for a business, you need to look first at how the seller’s industry defines “earnings”. This "earnings" measure reflects how much a buyer can afford to pay for the business. The actual multiple applied will be based on:
§ which definition of cash flow is being used,
§ what is appropriate for a given industry,
§ what the company’s specific growth prospects are,
§ how the company’s earnings compare with similar companies in the same industry, and finally
§ how the company’s earnings compare with the company’s asset value.
Richard E. Jackim, JD, MBA, CEPA is the author of the critically acclaimed book, “The $10 Trillion Opportunity: Designing Successful Exit Strategies for Middle Market Business Owners”, available at http://www.exit-planning-institute.org/
http://www.imakenews.com/epi_hfco/e_article001197834.cfm?x=bdnqbsy,w
As a trusted business advisor you’ve probably heard former business owners telling people that they sold their business for “six times earnings.” As investment bankers, the first question we hear from prospective clients is “Can I get the same multiple if I sell my business?” The answer is an unequivocal "it depends." It depends on a number of things, but first and foremost, it depends on how you define “earnings”.
As all investment bankers and sellers know, “Cash is King.” After all, cash removes the seller’s risk in the transaction. However, when a buyer pays cash for a business, that buyer wants to know exactly how much the business is earning.
Let’s start with what seems to be a pretty basic concept: earnings.
The Definitions of Earnings
There are several definitions of earnings; each is potentially different from the other depending on the type of company and the way its owner runs the company. Typical measures of earnings include:
§ Net Operating Income: This is sales less the cost of goods sold and operating expenses.
§ Pre-tax Income: This is net operating income plus non-operating income (like interest on notes, etc.) less non-operating expenses (like one-time, non-recurring expenses).
§ After-tax Income: Pre-tax income, less all company (but not individual) taxes.
§ EBIT: This stands for earnings before interest and taxes.
§ EBITDA: This stands for earnings before interest, taxes, depreciation and amortization
Add to these measures, the need to “adjust" earnings by deducting capital expenditures, and adding back excess rents, excessive salary and bonuses paid to the owner and his or her family. The result is something called:
Owner’s Discretionary Cash Flow or True Cash Flow: This is the amount of pre-tax money distributed to owners via salary, bonus, distributions from the company such as S-distributions, and rental payments in excess of fair market rental value of the equipment or building used in the business. This provides buyers with the most accurate indicator of how much “cash” a company can actually produce and is often the most meaningful indicator of value.
Which brings us back to our original question: Is it realistic for a business owner to expect a six times multiple when he sells his business? There is no one right or wrong answer to this question.
To show you how tricky this can be, let’s look at a former client of ours. His business was not doing well. He had revenues of approximately $7 million but, even using the most generous definition of earnings, the company was not earning more that about $100,000 per year. We ultimately sold the company to a buyer of distressed companies who paid book value for its assets or about $2 million. Despite this low value, our client was extremely happy because his business sold for 20 times earnings! In this case the buyer was buying assets, not earnings, so an earning multiple wasn’t even appropriate.
To determine which measure of earnings is appropriate for a business, you need to look first at how the seller’s industry defines “earnings”. This "earnings" measure reflects how much a buyer can afford to pay for the business. The actual multiple applied will be based on:
§ which definition of cash flow is being used,
§ what is appropriate for a given industry,
§ what the company’s specific growth prospects are,
§ how the company’s earnings compare with similar companies in the same industry, and finally
§ how the company’s earnings compare with the company’s asset value.
Richard E. Jackim, JD, MBA, CEPA is the author of the critically acclaimed book, “The $10 Trillion Opportunity: Designing Successful Exit Strategies for Middle Market Business Owners”, available at http://www.exit-planning-institute.org/
http://www.imakenews.com/epi_hfco/e_article001197834.cfm?x=bdnqbsy,w
New Approach to Uncertainty in Business Valuations
- applying a premium or discount to a capitalization rate, or
- adjusting future revenue and
- adjusting future expense projections.
Thomas E. McKee, CMA, CIA, PhD, CPA, is a visiting professor in the department of accounting and legal studies at the College of Charleston, Charleston, S.C.
Tuesday 10 November 2009
****Determining the value of a business is one of the most difficult aspects of any transaction
VALUING THE BUSINESS
Introduction
After deciding to buy or sell a business, the subject of "how much" becomes important. Determining the value of a business is one of the most difficult aspects of any transaction, since every business is unique.
A common misconception is that valuation is an exact science. While the use of formulas in a valuation implies exactness, it is very difficult to set the worth of a company at a single figure. To establish a fair market value, "hard" figures, such as assets, liabilities, and historical earnings and cash flow are used. But "soft," or subjective, figures, such as projected earnings, future cash flow, and the value of intangibles (e.g., patents, know-how, the quality of management, and leases at below-market rates) are also used. Soft figures also include such considerations as current market conditions, industry popularity, and, most important, the objectives of the seller or buyer. With all this subjectivity, fair market value can be, at best, only a range of estimates.
A second misconception is that value equals selling price. The final selling price can be either higher or lower than the estimated range of values for the company, depending on the eagerness of the buyer to buy and the seller to sell, the demand for the type of company, the
form of consideration paid, the negotiating skills of the parties, etc. In fact, the selling price of a company sometimes does not seem to have much relation to its estimated value.
Ask appraisers the value of your business and they will respond, "What's the purpose of the valuation?" Valuation methods -- and therefore values -- vary depending on the reason for the valuation. Different techniques can be used to arrive at different values, and each of the values may be correct for a specific situation. For purposes of this discussion, we will focus on the valuation techniques used for buying or selling a company as a going concern. Whichever technique is used, the valuation comprises these key elements:
Gathering Information
The selling memorandum, the basis for the buyers preliminary examination of the company, should contain comprehensive information about the company, its history and operations, and its market position. As a buyer, you will continue gathering all the information you can about the company through such sources as management interviews and conversations with the company's vendors and customers.
You will also want to gather similar information about competitors of similar size. In addition, you may want general information about the industry and the industry's leaders to help you understand market trends, competitive strategies, and the dynamics that cause companies in this particular industry to grow and succeed. Potential sources for industry and competitor information include market studies, reports of trade associations and credit rating agencies, and annual reports and stock analysts' reports of publicly owned companies.
Recasting Financial Statements
The historical financial statements may need to be adjusted to make them more meaningful or to compare them with those of the company's competitors. For example, take the financial statements of a closely held or family business whose objective in years past has been to minimize earnings in order to minimize corporate income taxes. To achieve this, the company may have awarded unusually large bonuses to employee-owners, masking the "true" earning power of the company. As the buyer or seller, you would want to recast, or normalize, the financial statements to account for this type of activity. In valuing a business, some typical income statement adjustments may include the following:
· Excessive management salaries.
· Salaries paid to individuals who can be replaced at much lower salaries.
· Retirement and health plans that provide better benefits than the plans of other companies in the industry.
· Excessive perquisites, such as company cars and club memberships.
· Favorable or unfavorable leases.
· Last-in-first-out (LIFO) inventory adjustments.
· Interest rates if the buyer borrows at significantly different rates.
· Adjustment of sales to reflect selling price increases, in cases where prices have not been increased recently and such increases would not have affected sales levels.
· Nonrecurring expenses, such as legal expenditures, relocation costs, and casualty losses.
· Accelerated depreciation charges, utilized to reduce taxable income.
· "Window dressing," or practices that temporarily improve current earnings. For instance, a company might reduce necessary long-term investments, such as research, advertising, or maintenance, improving its current earnings but weakening its potential for future earnings.
· Tax rates. If the company has an unusual tax situation, e.g., available net operating loss (NOL) carry forwards, an adjustment should be made to reflect "normal" taxation.
In valuing a business, some typical balance sheet adjustments may include the following:
· LIFO reserves, to adjust the inventory to current cost.
· Undervalued or overvalued marketable securities and investments in unconsolidated subsidiaries.
· Fixed assets that have appreciated in value.
· Intangible assets that may not be recorded on the books.
· Beneficial leases.
· Assumable debt with favorable interest rates or repayment terms.
· Unrecorded pension and other postretirement liabilities.
· Contingent liabilities.
After identifying and quantifying applicable adjustments, you will have a more meaningful set of financial statements to use to make financial projections and to compare the company's performance with that of other companies.
Projecting Earnings
Prospective financial information should be prepared for the next three to five years. If you are the seller, you probably have already prepared this information for your own purposes and included portions of it in the selling memorandum. If you are the buyer, however, chances are that you will want to do your own analysis. Prospective earnings may be estimated in one of three ways:
1. Use an average annual growth rate derived from the past three to five years' income as an estimate of future annual earnings. This method assumes that the earnings trend will remain essentially unchanged and, therefore, that historical earnings are a valid indicator
of future performance. The major disadvantage of using average historical growth rates is that past conditions may not remain the same in the future. Because business conditions are constantly changing, you should adjust for known and anticipated changes.
2. Use an estimate of future earnings under the current owners' management, adjusting for inflation and industry trends. This method of defining future earnings assumes that, after the sale, management will continue to operate the company in the same manner as past
management and with the same degree of success.
3. Use an estimate of future earnings under the new owners' management, adjusting for inflation and industry trends. This method is probably most useful to the buyer. It analyzes the effect that new management or strategies will have on future earnings. These effects include changes in marketing strategy, manufacturing technology, and management philosophy.
Comparisons with the Industry
Before proceeding to the valuation, the company's results, as restated, should be compared with the results of other companies in the industry and with the industry in general. Some of the comparative analysis should focus on the following figures:
· Sales growth.
· Gross margin.
· Earnings before income taxes, as a percentage of sales.
· Earnings before interest and income taxes, as a percentage of sales (this eliminates the financing bias)
· Earnings before depreciation, interest, and income tax, as a percentage of sales (this eliminates the historical cost bias as well as the financing bias).
· Return on equity
· Return on assets.
· Current ratio.
· Receivables and inventory turnover rates.
· Debt to net worth ratio
· Interest coverage.
Does the company under perform or outperform similar companies and the industry averages?
What is its growth rate relative to the industries?
Is it gaining or losing market share?
This analysis will give you some idea of whether the company deserves a premium or discount over the value of comparable companies. Wide fluctuations from the industry averages should be explained because they may indicate errors in the underlying data.
Valuation Method
The valuation method you select will be determined by your objectives for the valuation. As the seller, the objective is fairly clear -- to get the most for the company. As the buyer, however, your objective may not be as straightforward. It is important that you understand what you are buying and why you are buying it. The price you pay for an ongoing business may be quite different from the price you pay for a business that you intend to cannibalize for certain product lines or markets. For each purchase, a different valuation method may be appropriate.
Three approaches are commonly used in valuing a closely held business.
Balance Sheet Methods
Balance sheet methods of valuation are based on the concept that a buyer basically purchases the net assets of the company. Book value is probably the easiest method to apply. Using the company's financial statements, book value is simply calculated by subtracting total liabilities from total assets. The advantage of this method is that the numbers are usually readily available. Its drawbacks are numerous,
however. Book value does not reflect the fair market value of assets and liabilities; it expresses historical value only and is significantly affected by the company's accounting practices. It may not record, or may significantly undervalue, intangible assets such as patents and trademarks.
Lastly, book value ignores earnings potential. Despite these drawbacks, book value can be a useful point of reference when considering asset valuation.
Adjusted book value is simply the book value adjusted for major differences between the stated book value and the fair market value of the company's assets and liabilities. A refinement of book value, adjusted book value more accurately represents the value of a company's assets, but still has many of the same drawbacks.
One of the most significant typical balance sheet adjustments is the adjustment of the value of a company's intangible assets. This is also one of the most difficult. What is the value of an "ongoing" business? If a company has patents, trademarks, copyrights, or a proprietary
manufacturing process, how much are they worth? How much would it cost to develop similar processes, and could legal action result if the developed process were found to be too similar to a competitor's? What is the value of a company's existing customer base, long-term contracts, or exclusive license agreements? If you started a similar company tomorrow, how many months of losses would you have to incur before sales would reach profitable levels? Such questions make balance sheet methods a less effective measurement of business values for ongoing companies.
Despite these shortcomings, balance sheet methods have an appropriate place. For companies that are dependent on income-producing assets, such as real estate companies, banks, or leasing companies, balance sheet methods may provide the most reasonable valuation.
A less used balance sheet method is liquidation value. Liquidation value estimates the cash remaining after the company has sold all its assets and paid off all its liabilities. This method assumes that a bulk sale takes place, and therefore many of the prices you would get for the assets are lower than "fair market value." The liquidation may be orderly or forced, depending on the circumstances. In practice, only a business that is in severe financial difficulty or one that must be sold quickly (e.g., the owner has an immediate need for cash or a government order to sell has been issued) can be purchased at liquidation value. However, it is important to know this value during your negotiations. Financial institutions commonly use this method to determine the value of assets used as collateral to secure financing.
In applying any of the balance sheet methods, be alert to unrecorded liabilities that affect net asset value, such as noncancelable leases (if you intend to move), severance costs (if you are considering layoffs), or unfunded pension liabilities and other retiree benefits.
Market Comparables
This method determines a company's value by comparing the company with a similar public company or with recently sold similar businesses. While quite common in real estate transactions, this method is difficult to apply to most businesses because of the difficulty of
finding comparable businesses or transactions.
When suitable companies can be found, the price-earnings ratio of the comparable company (its stock price divided by its after-tax earnings per share) is typically used to determine value. Thus, if the stock of a comparable business trades in the public market at a price-earnings ratio of 12, the value of the candidate can be assumed to be 12 times its earnings.
Even if comparable companies can be found, this method is difficult to implement. Public companies are often engaged in diversified practices so that the price-earnings ratios may not be relevant. And since the companies are not identical, you must also consider whether your company should command a premium or discount. Possible price adjustments include the following:
· A premium for having anticipated earnings growth greater than expected industry norms.
· A discount for the additional risk of not enjoying the same liquidity as publicly traded stock. This adjustment could reduce the value by as much as30 to 50 percent for lack of marketability.
· A premium for acquiring control. If you want to acquire a controlling interest, you may need to pay a hefty premium to encourage other stockholders to sell their interest. This occurs frequently in both hostile and friendly takeovers. The premium can be quite substantial (40 to 50percent).
· Small Company discount. If your company is smaller than the average company in your industry, expect the buyer to use a price multiple for your company that is lower than the price multiples applicable to the market leader and other companies in your industry. This adjustment could reduce the value by as much as 30 percent. Despite these shortcomings, market comparables are very useful as reference points from which to value your company.
Earnings Methods
Various approaches are used to value future earnings power. Three of the more common approaches are capitalized earnings, discounted future earnings, and discounted cash flow. Capitalized earnings can be quickly computed and are often used to make preliminary estimates of value. They are calculated based on annual after-tax income. In using this method for valuing a company, you first determine your desired rate of return. The initial investment or value is then computed by dividing the average after-tax earnings by the desired rate of return. The major disadvantage of this method is that it does not take into account the time value of money. In addition, it assumes that the most recent earnings are a valid indicator of future performance.
VALCO, Inc.: Capitalized Earnings Method of Valuation
(Dollar amounts in thousands)
Assumptions:
After-tax income for the most recent year $750
Desired rate of return on investment 15%
Calculation of capitalized earnings:
Divide Income by rate of return
$750/.15=$5,000
The discounted future earnings method initially requires an estimate of after-tax income for future years (generally five to ten years), an estimate of value at the end of this future period ("residual value"), and the investor's desired rate of return. Each year's income and the residual value are then discounted (the process of dividing sums to be received in the future by an assumed earnings rate) by the desired rate of return. The sum of these discounted values is the estimated value (present value) of the company.
The inherent advantage of the discounted future earnings approach is that future earnings potential becomes the investment criterion, taking into account the time value of money.
Disadvantages include the fact that, like any estimate, future earnings cannot be projected with certainty. Residual value, which may be affected by industry and economic uncertainties, the buyer's intent, and other factors, is also difficult to project. Finally, it may not be possible to reinvest all earnings because of practical limitations imposed by the business environment and because earnings do not necessarily take the form of cash.
The first two disadvantages can be overcome to some extent by using computing models based on optimistic, pessimistic, and most-likely outcomes for future earnings and residual value. The last disadvantage can be overcome by using the discounted cash flow method. This method is essentially the same as the discounted future earnings method, except that cash flow rather than income is projected for each future year. Many consider this method the best for determining value. In many cases cash flow is a more important consideration than profits, as in the case of a heavily leveraged transaction.
Determining the Final Value
The buyer and seller will each conduct their own analysis to estimate the future earnings and cash flows and assess their own risk tolerance in order to estimate the company's value. For example, the buyer may feel this is a moderately risky opportunity requiring a 15 percent aftertax return to compete with other available investment opportunities. As the perceived risk increases, so does the discount rate, which reduces the current value of the company. The seller, on the other hand, may determine that his or her next best investment opportunity will yield a maximum after-tax return of 10 percent, and he or she will require a similar discount to sell this business. In valuing the business, the buyer's and seller's results can be significantly different.
The parties should not spend much time arguing about the mechanics of how they arrived at their valuations other than to understand the assumptions and techniques used. Since they each have different views on risk, growth, etc., there is little point in trying to agree on "value."
Use your value as a guide for developing your negotiating strategy. As the buyer, your value will be the maximum price that makes sense taking into account the perceived riskiness of the transaction and the funding available to you. As the seller, your value will be the minimum you are willing to accept considering your alternative uses for the funds from the sale.
For more resources to Start or Grow Small Business, visit our website at http://www.womensenterprise.ca/ or call 1.800.643.7014
http://www.womensenterprise.ca/resources/downloads/valuing-business.pdf
Introduction
After deciding to buy or sell a business, the subject of "how much" becomes important. Determining the value of a business is one of the most difficult aspects of any transaction, since every business is unique.
A common misconception is that valuation is an exact science. While the use of formulas in a valuation implies exactness, it is very difficult to set the worth of a company at a single figure. To establish a fair market value, "hard" figures, such as assets, liabilities, and historical earnings and cash flow are used. But "soft," or subjective, figures, such as projected earnings, future cash flow, and the value of intangibles (e.g., patents, know-how, the quality of management, and leases at below-market rates) are also used. Soft figures also include such considerations as current market conditions, industry popularity, and, most important, the objectives of the seller or buyer. With all this subjectivity, fair market value can be, at best, only a range of estimates.
A second misconception is that value equals selling price. The final selling price can be either higher or lower than the estimated range of values for the company, depending on the eagerness of the buyer to buy and the seller to sell, the demand for the type of company, the
form of consideration paid, the negotiating skills of the parties, etc. In fact, the selling price of a company sometimes does not seem to have much relation to its estimated value.
Ask appraisers the value of your business and they will respond, "What's the purpose of the valuation?" Valuation methods -- and therefore values -- vary depending on the reason for the valuation. Different techniques can be used to arrive at different values, and each of the values may be correct for a specific situation. For purposes of this discussion, we will focus on the valuation techniques used for buying or selling a company as a going concern. Whichever technique is used, the valuation comprises these key elements:
- gathering information about the company and the industry;
- recasting the historical financial statements;
- preparing prospective financial statements;
- comparing the company's results with those of other companies in the industry; and,
- finally, applying appropriate valuation methodologies.
Gathering Information
The selling memorandum, the basis for the buyers preliminary examination of the company, should contain comprehensive information about the company, its history and operations, and its market position. As a buyer, you will continue gathering all the information you can about the company through such sources as management interviews and conversations with the company's vendors and customers.
You will also want to gather similar information about competitors of similar size. In addition, you may want general information about the industry and the industry's leaders to help you understand market trends, competitive strategies, and the dynamics that cause companies in this particular industry to grow and succeed. Potential sources for industry and competitor information include market studies, reports of trade associations and credit rating agencies, and annual reports and stock analysts' reports of publicly owned companies.
Recasting Financial Statements
The historical financial statements may need to be adjusted to make them more meaningful or to compare them with those of the company's competitors. For example, take the financial statements of a closely held or family business whose objective in years past has been to minimize earnings in order to minimize corporate income taxes. To achieve this, the company may have awarded unusually large bonuses to employee-owners, masking the "true" earning power of the company. As the buyer or seller, you would want to recast, or normalize, the financial statements to account for this type of activity. In valuing a business, some typical income statement adjustments may include the following:
· Excessive management salaries.
· Salaries paid to individuals who can be replaced at much lower salaries.
· Retirement and health plans that provide better benefits than the plans of other companies in the industry.
· Excessive perquisites, such as company cars and club memberships.
· Favorable or unfavorable leases.
· Last-in-first-out (LIFO) inventory adjustments.
· Interest rates if the buyer borrows at significantly different rates.
· Adjustment of sales to reflect selling price increases, in cases where prices have not been increased recently and such increases would not have affected sales levels.
· Nonrecurring expenses, such as legal expenditures, relocation costs, and casualty losses.
· Accelerated depreciation charges, utilized to reduce taxable income.
· "Window dressing," or practices that temporarily improve current earnings. For instance, a company might reduce necessary long-term investments, such as research, advertising, or maintenance, improving its current earnings but weakening its potential for future earnings.
· Tax rates. If the company has an unusual tax situation, e.g., available net operating loss (NOL) carry forwards, an adjustment should be made to reflect "normal" taxation.
In valuing a business, some typical balance sheet adjustments may include the following:
· LIFO reserves, to adjust the inventory to current cost.
· Undervalued or overvalued marketable securities and investments in unconsolidated subsidiaries.
· Fixed assets that have appreciated in value.
· Intangible assets that may not be recorded on the books.
· Beneficial leases.
· Assumable debt with favorable interest rates or repayment terms.
· Unrecorded pension and other postretirement liabilities.
· Contingent liabilities.
After identifying and quantifying applicable adjustments, you will have a more meaningful set of financial statements to use to make financial projections and to compare the company's performance with that of other companies.
Projecting Earnings
Prospective financial information should be prepared for the next three to five years. If you are the seller, you probably have already prepared this information for your own purposes and included portions of it in the selling memorandum. If you are the buyer, however, chances are that you will want to do your own analysis. Prospective earnings may be estimated in one of three ways:
1. Use an average annual growth rate derived from the past three to five years' income as an estimate of future annual earnings. This method assumes that the earnings trend will remain essentially unchanged and, therefore, that historical earnings are a valid indicator
of future performance. The major disadvantage of using average historical growth rates is that past conditions may not remain the same in the future. Because business conditions are constantly changing, you should adjust for known and anticipated changes.
2. Use an estimate of future earnings under the current owners' management, adjusting for inflation and industry trends. This method of defining future earnings assumes that, after the sale, management will continue to operate the company in the same manner as past
management and with the same degree of success.
3. Use an estimate of future earnings under the new owners' management, adjusting for inflation and industry trends. This method is probably most useful to the buyer. It analyzes the effect that new management or strategies will have on future earnings. These effects include changes in marketing strategy, manufacturing technology, and management philosophy.
Comparisons with the Industry
Before proceeding to the valuation, the company's results, as restated, should be compared with the results of other companies in the industry and with the industry in general. Some of the comparative analysis should focus on the following figures:
· Sales growth.
· Gross margin.
· Earnings before income taxes, as a percentage of sales.
· Earnings before interest and income taxes, as a percentage of sales (this eliminates the financing bias)
· Earnings before depreciation, interest, and income tax, as a percentage of sales (this eliminates the historical cost bias as well as the financing bias).
· Return on equity
· Return on assets.
· Current ratio.
· Receivables and inventory turnover rates.
· Debt to net worth ratio
· Interest coverage.
Does the company under perform or outperform similar companies and the industry averages?
What is its growth rate relative to the industries?
Is it gaining or losing market share?
This analysis will give you some idea of whether the company deserves a premium or discount over the value of comparable companies. Wide fluctuations from the industry averages should be explained because they may indicate errors in the underlying data.
Valuation Method
The valuation method you select will be determined by your objectives for the valuation. As the seller, the objective is fairly clear -- to get the most for the company. As the buyer, however, your objective may not be as straightforward. It is important that you understand what you are buying and why you are buying it. The price you pay for an ongoing business may be quite different from the price you pay for a business that you intend to cannibalize for certain product lines or markets. For each purchase, a different valuation method may be appropriate.
Three approaches are commonly used in valuing a closely held business.
- The first approach uses the balance sheet to arrive at the fair value of net assets;
- the second examines market comparables; and
- the third analyzes the future income or potential cash flow of the company.
Balance Sheet Methods
Balance sheet methods of valuation are based on the concept that a buyer basically purchases the net assets of the company. Book value is probably the easiest method to apply. Using the company's financial statements, book value is simply calculated by subtracting total liabilities from total assets. The advantage of this method is that the numbers are usually readily available. Its drawbacks are numerous,
however. Book value does not reflect the fair market value of assets and liabilities; it expresses historical value only and is significantly affected by the company's accounting practices. It may not record, or may significantly undervalue, intangible assets such as patents and trademarks.
Lastly, book value ignores earnings potential. Despite these drawbacks, book value can be a useful point of reference when considering asset valuation.
Adjusted book value is simply the book value adjusted for major differences between the stated book value and the fair market value of the company's assets and liabilities. A refinement of book value, adjusted book value more accurately represents the value of a company's assets, but still has many of the same drawbacks.
One of the most significant typical balance sheet adjustments is the adjustment of the value of a company's intangible assets. This is also one of the most difficult. What is the value of an "ongoing" business? If a company has patents, trademarks, copyrights, or a proprietary
manufacturing process, how much are they worth? How much would it cost to develop similar processes, and could legal action result if the developed process were found to be too similar to a competitor's? What is the value of a company's existing customer base, long-term contracts, or exclusive license agreements? If you started a similar company tomorrow, how many months of losses would you have to incur before sales would reach profitable levels? Such questions make balance sheet methods a less effective measurement of business values for ongoing companies.
Despite these shortcomings, balance sheet methods have an appropriate place. For companies that are dependent on income-producing assets, such as real estate companies, banks, or leasing companies, balance sheet methods may provide the most reasonable valuation.
A less used balance sheet method is liquidation value. Liquidation value estimates the cash remaining after the company has sold all its assets and paid off all its liabilities. This method assumes that a bulk sale takes place, and therefore many of the prices you would get for the assets are lower than "fair market value." The liquidation may be orderly or forced, depending on the circumstances. In practice, only a business that is in severe financial difficulty or one that must be sold quickly (e.g., the owner has an immediate need for cash or a government order to sell has been issued) can be purchased at liquidation value. However, it is important to know this value during your negotiations. Financial institutions commonly use this method to determine the value of assets used as collateral to secure financing.
In applying any of the balance sheet methods, be alert to unrecorded liabilities that affect net asset value, such as noncancelable leases (if you intend to move), severance costs (if you are considering layoffs), or unfunded pension liabilities and other retiree benefits.
Market Comparables
This method determines a company's value by comparing the company with a similar public company or with recently sold similar businesses. While quite common in real estate transactions, this method is difficult to apply to most businesses because of the difficulty of
finding comparable businesses or transactions.
When suitable companies can be found, the price-earnings ratio of the comparable company (its stock price divided by its after-tax earnings per share) is typically used to determine value. Thus, if the stock of a comparable business trades in the public market at a price-earnings ratio of 12, the value of the candidate can be assumed to be 12 times its earnings.
Even if comparable companies can be found, this method is difficult to implement. Public companies are often engaged in diversified practices so that the price-earnings ratios may not be relevant. And since the companies are not identical, you must also consider whether your company should command a premium or discount. Possible price adjustments include the following:
· A premium for having anticipated earnings growth greater than expected industry norms.
· A discount for the additional risk of not enjoying the same liquidity as publicly traded stock. This adjustment could reduce the value by as much as30 to 50 percent for lack of marketability.
· A premium for acquiring control. If you want to acquire a controlling interest, you may need to pay a hefty premium to encourage other stockholders to sell their interest. This occurs frequently in both hostile and friendly takeovers. The premium can be quite substantial (40 to 50percent).
· Small Company discount. If your company is smaller than the average company in your industry, expect the buyer to use a price multiple for your company that is lower than the price multiples applicable to the market leader and other companies in your industry. This adjustment could reduce the value by as much as 30 percent. Despite these shortcomings, market comparables are very useful as reference points from which to value your company.
Earnings Methods
Various approaches are used to value future earnings power. Three of the more common approaches are capitalized earnings, discounted future earnings, and discounted cash flow. Capitalized earnings can be quickly computed and are often used to make preliminary estimates of value. They are calculated based on annual after-tax income. In using this method for valuing a company, you first determine your desired rate of return. The initial investment or value is then computed by dividing the average after-tax earnings by the desired rate of return. The major disadvantage of this method is that it does not take into account the time value of money. In addition, it assumes that the most recent earnings are a valid indicator of future performance.
VALCO, Inc.: Capitalized Earnings Method of Valuation
(Dollar amounts in thousands)
Assumptions:
After-tax income for the most recent year $750
Desired rate of return on investment 15%
Calculation of capitalized earnings:
Divide Income by rate of return
$750/.15=$5,000
The discounted future earnings method initially requires an estimate of after-tax income for future years (generally five to ten years), an estimate of value at the end of this future period ("residual value"), and the investor's desired rate of return. Each year's income and the residual value are then discounted (the process of dividing sums to be received in the future by an assumed earnings rate) by the desired rate of return. The sum of these discounted values is the estimated value (present value) of the company.
The inherent advantage of the discounted future earnings approach is that future earnings potential becomes the investment criterion, taking into account the time value of money.
Disadvantages include the fact that, like any estimate, future earnings cannot be projected with certainty. Residual value, which may be affected by industry and economic uncertainties, the buyer's intent, and other factors, is also difficult to project. Finally, it may not be possible to reinvest all earnings because of practical limitations imposed by the business environment and because earnings do not necessarily take the form of cash.
The first two disadvantages can be overcome to some extent by using computing models based on optimistic, pessimistic, and most-likely outcomes for future earnings and residual value. The last disadvantage can be overcome by using the discounted cash flow method. This method is essentially the same as the discounted future earnings method, except that cash flow rather than income is projected for each future year. Many consider this method the best for determining value. In many cases cash flow is a more important consideration than profits, as in the case of a heavily leveraged transaction.
Determining the Final Value
The buyer and seller will each conduct their own analysis to estimate the future earnings and cash flows and assess their own risk tolerance in order to estimate the company's value. For example, the buyer may feel this is a moderately risky opportunity requiring a 15 percent aftertax return to compete with other available investment opportunities. As the perceived risk increases, so does the discount rate, which reduces the current value of the company. The seller, on the other hand, may determine that his or her next best investment opportunity will yield a maximum after-tax return of 10 percent, and he or she will require a similar discount to sell this business. In valuing the business, the buyer's and seller's results can be significantly different.
The parties should not spend much time arguing about the mechanics of how they arrived at their valuations other than to understand the assumptions and techniques used. Since they each have different views on risk, growth, etc., there is little point in trying to agree on "value."
Use your value as a guide for developing your negotiating strategy. As the buyer, your value will be the maximum price that makes sense taking into account the perceived riskiness of the transaction and the funding available to you. As the seller, your value will be the minimum you are willing to accept considering your alternative uses for the funds from the sale.
For more resources to Start or Grow Small Business, visit our website at http://www.womensenterprise.ca/ or call 1.800.643.7014
VALUING TECHNOLOGY BUSINESSES
One of the most important questions for any business owner is “What’s my business worth?” to which, the stock answer is “It depends.” This paper explains the factors affecting the valuation of a business. This is useful not only when selling a company, but also when bringing in new investors who buy a piece of the company.
Valuation thoughts and concepts
The fundamentals underlying the valuation of a business are no different than those for other things we buy and sell such are houses, cars, old furniture, etc.
Value is:
- Based on perception: “Beauty is in the eye of the beholder.” A house that one person perceives needs a lot of work is a “fixer upper” to someone else who sees an opportunity to turn his sweat into profit. The same exists for businesses.
- Personal: “What is it worth to me.” A 1957 Chevy has more value to someone for whom this brings back fond memories than to someone who sees an old car with a rough engine and no air conditioning. A business is worth more to someone who has successfully run similar enterprises.
- Relative: “Different values for different people”. Closing a sale (both parties agreeing to a value) is as much an art as a science. It is a matter of both parties seeing benefit in making the deal.
Read on:
http://www.corp21.com/Valuation.pdf
Valuation thoughts and concepts
The fundamentals underlying the valuation of a business are no different than those for other things we buy and sell such are houses, cars, old furniture, etc.
Value is:
- Based on perception: “Beauty is in the eye of the beholder.” A house that one person perceives needs a lot of work is a “fixer upper” to someone else who sees an opportunity to turn his sweat into profit. The same exists for businesses.
- Personal: “What is it worth to me.” A 1957 Chevy has more value to someone for whom this brings back fond memories than to someone who sees an old car with a rough engine and no air conditioning. A business is worth more to someone who has successfully run similar enterprises.
- Relative: “Different values for different people”. Closing a sale (both parties agreeing to a value) is as much an art as a science. It is a matter of both parties seeing benefit in making the deal.
Read on:
http://www.corp21.com/Valuation.pdf
Valuing uncertainty
Valuing uncertainty
Author: Andrew Kent on 26 February 2009
A key issue with business valuations is the level of certainty that can be placed on future earnings. The optimistic seller wants potential growth factored into the numbers, while the pessimistic buyer would like to exclude anything that customers are not contractually committed to. With this in mind one may wonder how any transactions occur at all. Fortunately not all sellers are optimistic and not all buyers are pessimistic; indeed when the sellers are pessimistic and the buyers are optimistic, both walk away happy with the deal.
However the majority of business sales involve people who basically want a fair deal - they might fear being ripped off, they might hope for a great deal, but they generally expect a fair deal.
The issue that makes both sides feel uncomfortable is determining what a genuinely fair deal is. The underlying problem is that what is being sold is the future of the business, not its past. As the future is uncertain, so is the value of the business.
To this end, a source of comfort becomes what other people have paid for similar businesses. This can be found at http://www.valuemybusiness.com.au/ and can also be obtained from advisers and brokers that specialise in specific industries.
What many business owners find difficult to understand is why the sale value and the book value of the business are not the same thing. The fact is that these have never been the same.
Historically the difference in value has been catered for by adding a figure for goodwill if the sale price is higher than the book value. Alternately, if the sale price is lower than the book value, then the asset values are adjusted down through write-offs.
The reason that the sale value and the book value are different is because the book value is based on the businesses past, while the sale value is based on the businesses future.
In today's market, there is a strong move away from discussions of goodwill and asset prices to a focus on EBIT and EBIT multiples. A key reason for this is that the asset structure of most businesses has fundamentally changed from owning property, plant and equipment to leasing it.
As a result many businesses have ongoing liabilities that exceed their debtors and forward orders. This is not because a business is in bad shape, but rather a reflection of the timeframe for the lease commitment exceeds the timeframes for sales commitments.
So the key discussion point and negotiating point will be around the sale forecast.
Anyone in business today knows that the horizon of certainty on a sales forecast is shorter than it has ever been, so what value will you place on what is beyond the horizon?
http://www.smartcompany.com.au/selling-your-business/valuing-uncertainty.html
Author: Andrew Kent on 26 February 2009
A key issue with business valuations is the level of certainty that can be placed on future earnings. The optimistic seller wants potential growth factored into the numbers, while the pessimistic buyer would like to exclude anything that customers are not contractually committed to. With this in mind one may wonder how any transactions occur at all. Fortunately not all sellers are optimistic and not all buyers are pessimistic; indeed when the sellers are pessimistic and the buyers are optimistic, both walk away happy with the deal.
However the majority of business sales involve people who basically want a fair deal - they might fear being ripped off, they might hope for a great deal, but they generally expect a fair deal.
The issue that makes both sides feel uncomfortable is determining what a genuinely fair deal is. The underlying problem is that what is being sold is the future of the business, not its past. As the future is uncertain, so is the value of the business.
To this end, a source of comfort becomes what other people have paid for similar businesses. This can be found at http://www.valuemybusiness.com.au/ and can also be obtained from advisers and brokers that specialise in specific industries.
What many business owners find difficult to understand is why the sale value and the book value of the business are not the same thing. The fact is that these have never been the same.
Historically the difference in value has been catered for by adding a figure for goodwill if the sale price is higher than the book value. Alternately, if the sale price is lower than the book value, then the asset values are adjusted down through write-offs.
The reason that the sale value and the book value are different is because the book value is based on the businesses past, while the sale value is based on the businesses future.
In today's market, there is a strong move away from discussions of goodwill and asset prices to a focus on EBIT and EBIT multiples. A key reason for this is that the asset structure of most businesses has fundamentally changed from owning property, plant and equipment to leasing it.
As a result many businesses have ongoing liabilities that exceed their debtors and forward orders. This is not because a business is in bad shape, but rather a reflection of the timeframe for the lease commitment exceeds the timeframes for sales commitments.
So the key discussion point and negotiating point will be around the sale forecast.
Anyone in business today knows that the horizon of certainty on a sales forecast is shorter than it has ever been, so what value will you place on what is beyond the horizon?
http://www.smartcompany.com.au/selling-your-business/valuing-uncertainty.html
3 Business Valuation Methods
3 Business Valuation Methods
How to Determine What Your Business Is Worth
By Susan Ward, About.com
Definition Valuation
How much your business is worth depends on many factors, from the current state of the economy through your business’s balance sheet.
Let me say up front that I do not believe that business owners should do their own business valuation. This is too much like asking a mother how talented her child is. Neither the business owner nor the mother has the necessary distance to step back and answer the question objectively.
So to ensure that you set and get the best price when you're selling a business, I recommend getting a business valuation done by a professional, such as a Chartered Business Valuator (CBV). In Canada, you can find Business Valuators through the yellow pages or through the website of the Canadian Institute of Chartered Business Valuators.
A Business Valuator (or anyone valuating your business) will use a variety of business valuation methods to determine a fair price for your business, such as:
1) Asset-based approaches
Basically these business valuation methods total up all the investments in the business. Asset-based business valuations can be done on a going concern or on a liquidation basis.
•A going concern asset-based approach lists the business net balance sheet value of its assets and subtracts the value of its liabilities.
•A liquidation asset-based approach determines the net cash that would be received if all assets were sold and liabilities paid off.
2) Earning value approaches
These business valuation methods are predicated on the idea that a business's true value lies in its ability to produce wealth in the future. The most common earning value approach is Capitalizing Past Earning.
With this approach, a valuator determines an expected level of cash flow for the company using a company's record of past earnings, normalizes them for unusual revenue or expenses, and multiplies the expected normalized cash flows by a capitalization factor. The capitalization factor is a reflection of what rate of return a reasonable purchaser would expect on the investment, as well as a measure of the risk that the expected earnings will not be achieved.
Discounted Future Earnings is another earning value approach to business valuation where instead of an average of past earnings, an average of the trend of predicted future earnings is used and divided by the capitalization factor.
What might such capitalization rates be? In a Management Issues paper discussing "How Much Is Your Business Worth?", Grant Thornton LLP suggests:
“Well established businesses with a history of strong earnings and good market share might often trade with a capitalization rate of, say 12% to 20%. Unproven businesses in a fluctuating and volatile market tend to trade at much higher capitalization rates, say 25% to 50%.”
3) Market value approaches
Market value approaches to business valuation attempt to establish the value of your business by comparing your business to similar businesses that have recently sold. Obviously, this method is only going to work well if there are a sufficient number of similar businesses to compare.
Although the Earning Value Approach is the most popular business valuation method, for most businesses, some combination of business valuation methods will be the fairest way to set a selling price.
http://sbinfocanada.about.com/od/sellingabusiness/a/bizvaluation.htm
How to Determine What Your Business Is Worth
By Susan Ward, About.com
Definition Valuation
How much your business is worth depends on many factors, from the current state of the economy through your business’s balance sheet.
Let me say up front that I do not believe that business owners should do their own business valuation. This is too much like asking a mother how talented her child is. Neither the business owner nor the mother has the necessary distance to step back and answer the question objectively.
So to ensure that you set and get the best price when you're selling a business, I recommend getting a business valuation done by a professional, such as a Chartered Business Valuator (CBV). In Canada, you can find Business Valuators through the yellow pages or through the website of the Canadian Institute of Chartered Business Valuators.
A Business Valuator (or anyone valuating your business) will use a variety of business valuation methods to determine a fair price for your business, such as:
1) Asset-based approaches
Basically these business valuation methods total up all the investments in the business. Asset-based business valuations can be done on a going concern or on a liquidation basis.
•A going concern asset-based approach lists the business net balance sheet value of its assets and subtracts the value of its liabilities.
•A liquidation asset-based approach determines the net cash that would be received if all assets were sold and liabilities paid off.
2) Earning value approaches
These business valuation methods are predicated on the idea that a business's true value lies in its ability to produce wealth in the future. The most common earning value approach is Capitalizing Past Earning.
With this approach, a valuator determines an expected level of cash flow for the company using a company's record of past earnings, normalizes them for unusual revenue or expenses, and multiplies the expected normalized cash flows by a capitalization factor. The capitalization factor is a reflection of what rate of return a reasonable purchaser would expect on the investment, as well as a measure of the risk that the expected earnings will not be achieved.
Discounted Future Earnings is another earning value approach to business valuation where instead of an average of past earnings, an average of the trend of predicted future earnings is used and divided by the capitalization factor.
What might such capitalization rates be? In a Management Issues paper discussing "How Much Is Your Business Worth?", Grant Thornton LLP suggests:
“Well established businesses with a history of strong earnings and good market share might often trade with a capitalization rate of, say 12% to 20%. Unproven businesses in a fluctuating and volatile market tend to trade at much higher capitalization rates, say 25% to 50%.”
3) Market value approaches
Market value approaches to business valuation attempt to establish the value of your business by comparing your business to similar businesses that have recently sold. Obviously, this method is only going to work well if there are a sufficient number of similar businesses to compare.
Although the Earning Value Approach is the most popular business valuation method, for most businesses, some combination of business valuation methods will be the fairest way to set a selling price.
http://sbinfocanada.about.com/od/sellingabusiness/a/bizvaluation.htm
“WHAT IS MY BUSINESS WORTH”?
Valuing a Business
“WHAT IS MY BUSINESS WORTH”?
This is the top question of every business owner when deciding if it is time to sell. Anyone that has ever sold a home knows that an independent appraisal report had to be completed for the mortgage company to complete the sale. A business is many times more complex and usually the single largest asset a person owns. The key to making sound decisions and obtaining full value for your business is to have a viable valuation performed by an independent third-party valuation service. Without this report, a business owner should be prepared for heavy negotiations because it will be your opinion versus the buyer’s opinion.
Be wary of any business broker who prepares his own in-house valuation or tells you “what he can get” for your business. Many times they are simply telling you what they think you want to hear in order to get a listing. In addition, a buyer will place no credibility in that opinion because he has a vested interest in obtaining a higher price than can be justified.
Advanced Business Group uses the services of some of the largest, independent third-party valuation services in America to perform these reports for our clients who are trying to secure full market value for their business. They perform thousands of business valuations each year and have the largest data base of closed transactions in the nation. They know what price other businesses, like yours, are really producing. Their reports are reader friendly and can be shown to prospective buyers. They go much further than just value, they recommend which assets and liabilities to sell and the deal structure that will most likely produce a completed transaction at the best price. On top of that, they will totally justify that the recommended price is best for the business owner and yet realistic for a prospective buyer.
Business brokers have consistently produced higher prices and smoother sales with a valuation than similar businesses produced that did not have the valuation. The reasons are simple:
1) Knowing the value of your business before you go to market allows you to best package and present the company to buyers,
2) Allows us to learn as much as possible about your business without actually working there and thereby being capable of putting your best foot forward when talking with buyers, and
3) Brings a better quality buyer to the table because they know the business has good value.
Valuing a Business-For Other Reasons
Value Enhancement
Divorce
Buy/Sell Agreements
Gift/Estate Tax
ESOPS
Family Succession
Loans/Financing
Life Insurance
Shareholder Disputes
Estate Planning
Partnerships
Mergers
Raising Capital
Business & Strategic Planning
You never have to guess when it comes to something this important.
http://www.businessbuysellvalue.com/ContentPage.aspx?WebPageId=6634&GroupId=1692
“WHAT IS MY BUSINESS WORTH”?
This is the top question of every business owner when deciding if it is time to sell. Anyone that has ever sold a home knows that an independent appraisal report had to be completed for the mortgage company to complete the sale. A business is many times more complex and usually the single largest asset a person owns. The key to making sound decisions and obtaining full value for your business is to have a viable valuation performed by an independent third-party valuation service. Without this report, a business owner should be prepared for heavy negotiations because it will be your opinion versus the buyer’s opinion.
Be wary of any business broker who prepares his own in-house valuation or tells you “what he can get” for your business. Many times they are simply telling you what they think you want to hear in order to get a listing. In addition, a buyer will place no credibility in that opinion because he has a vested interest in obtaining a higher price than can be justified.
Advanced Business Group uses the services of some of the largest, independent third-party valuation services in America to perform these reports for our clients who are trying to secure full market value for their business. They perform thousands of business valuations each year and have the largest data base of closed transactions in the nation. They know what price other businesses, like yours, are really producing. Their reports are reader friendly and can be shown to prospective buyers. They go much further than just value, they recommend which assets and liabilities to sell and the deal structure that will most likely produce a completed transaction at the best price. On top of that, they will totally justify that the recommended price is best for the business owner and yet realistic for a prospective buyer.
Business brokers have consistently produced higher prices and smoother sales with a valuation than similar businesses produced that did not have the valuation. The reasons are simple:
1) Knowing the value of your business before you go to market allows you to best package and present the company to buyers,
2) Allows us to learn as much as possible about your business without actually working there and thereby being capable of putting your best foot forward when talking with buyers, and
3) Brings a better quality buyer to the table because they know the business has good value.
Valuing a Business-For Other Reasons
Value Enhancement
Divorce
Buy/Sell Agreements
Gift/Estate Tax
ESOPS
Family Succession
Loans/Financing
Life Insurance
Shareholder Disputes
Estate Planning
Partnerships
Mergers
Raising Capital
Business & Strategic Planning
You never have to guess when it comes to something this important.
http://www.businessbuysellvalue.com/ContentPage.aspx?WebPageId=6634&GroupId=1692
How To Value A Business
How To Value A Business
By Richard Parker: President of The Business Buyer Resource Center and author of How To Buy A Good Business At A Great Price ©
Accurately valuing a small business is often the most challenging part of the process for prospective business buyers. However, it doesn’t have to be an overwhelming or difficult undertaking. Above all, you should realize that valuation is an art, not a science. As a buyer, always keep in mind that the “Asking Price” is NOT the purchase price. Quite often it does not even remotely represent what the business is truly worth.
Naturally, a buyer’s valuation is usually quite different from what the seller believes their business is worth. Sellers are emotionally attached to their businesses. They usually factor their years of hard work into their calculation. Unfortunately, this has no business whatsoever being in the equation.
The challenge for you, the buyer, is to formulate a valuation that is accurate, and will prove to provide you with an acceptable return on your investment.
There are several ways to calculate the value of a business:
Asset Valuations: Calculates the value of all of the assets of a business and arrives at the appropriate price.
Liquidation Value: Determines the value of the company’s assets if it were forced to sell all of them in a short period of time (usually less than 12 months).
Income Capitalization: Future income is calculated based upon historical data and a variety of assumptions.
Income Multiple: The net income (profit/owner's benefit/seller's cash flow) of a business is subject to a certain multiple to arrive at a selling price.
Rules Of Thumb: The selling price of other “like” businesses is used as a multiple of cash flow or a percentage of revenue.
Asset-based valuations do not work for small business purchases. Assets are used to generate revenue and nothing more. If a business is "asset rich" but doesn't make much money, how valuable is the business altogether? Conversely, if a business has limited assets, such as computers and office equipment, but makes a ton of money, isn't it worth more?
Income Capitalization is generally applicable to large businesses and most often uses a factor that is far too arbitrary.
"The key to making good decisions in life is education. There has always been a void in effective buyer educational tools until the course How To Buy A Good Business At A Great Price came along."
The “Rule of Thumb” method is too general. It's hard to find any two businesses that are exactly the same. Valuation must be done based upon what you, as the buyer, can reasonably expect to generate in your pocket, so long as the business’ future is representative of the past historical financial data.
The Multiple Method is clearly the way to go. You have probably heard of businesses selling at “x times earnings”. However, this can be quite subjective because earnings can actually mean different things in different businesses. When buying a small business, every buyer wants to know how much money he or she can expect to make from the business. Therefore, the most effective number to use as the basis of your calculation is what is known as the total “Owner Benefits”.
Note: You will come across different terms on various websites and in business for sale profiles for Owner's Benefit such as Seller's Discretionary Earnings, Adjusted Earnings, and others as well. Make certain that the seller provides you with the exact formula of how they arrived at this figure - this is critical.
The Owner Benefit amount is the total dollars that you can expect to have available from the business (based upon the past financials) to pay yourself a salary, service any debt, and marklet the business assuming that everything remains status quo after you take over. The beauty is that unlike other methods (i.e. Income Cap), it does not attempt to predict the future. Nobody can do that.
(Very Important: Owner's Benefit is not cash flow and cash flow is not profit. Cash Flow is probably the most misunderstood and misused accounting term. Cash Flow is simply the amount of cash a business had at the beginning of a period, how much it had at the end of a period and what happened in between to it.)
The theory behind the Owner Benefit number is to take the business’ profits plus the owner’s salary and benefits and then to add back the non-cash expenses. History has shown that this methodology, while not bulletproof, is the most effective way to establish the valuation basis of a small business. Then, a multiple, based upon a variety of factors, is applied to this number and a valuation is established.
The Owner Benefit formula to use is:
Pre-Tax Profit + Owner’s Salary + Additional Owner Perks + Interest + Depreciation LESS Allowance for Capital Expenditures
Why Add Back Depreciation?
Depreciation is an expense that allows a business to deduct a certain amount of money each year from an asset so that its purchase value is reduced by its overall useful life. As an example: if the business buys a $25,000 truck and its useful life is estimated at 5 years, then each year the company can deduct $5000 off its income to lessen its tax burden. However, as you can see, it is not an actual cash transaction. No money is physically leaving the business or changing hands. Therefore, this amount is added back.
Why Add Back Interest?
Each business owner will have separate philosophies for borrowing for the business and how to best use borrowed funds, if necessary at all. Furthermore, in nearly all cases, the seller will pay off the business’ loans from their proceeds at selling; therefore, you will have use of these additional funds.
A Note About Add-Backs (Capital Expenditure Allowance)
After completing any add-backs, it is critical that you take into consideration the future capital requirements of the business as well as debt-service expenses. As such, in capital-intensive businesses where equipment needs replacing on a regular basis, you must deduct appropriate amounts from the Owner Benefit number in order to determine both the true value of the business as well as its ability to fund future expenditures. Under this formula, you will arrive at a "net" Owner Benefit number or true Free Cash Flow figure.
"I've just completed the purchase of an established business with a 30-year history, now retiring its second owner. Your guide was perfect in helping me select this business, especially in assessing its value. Thanks again for your personal attention to my purchase and pursuits."
Gil Takemori - San Jose, CA
What Multiple?
Typically, small businesses will sell in a one to three-times multiple of this figure. Now, this is a wide range, and some businesses will sell for more, so how do you determine what to apply? The best general rule to keep in mind und is that a one-time multiple is for those businesses where the seller is “the business”. In other words: "as out the door goes the seller, so too can go the customers". Consulting businesses, professional practices, and one-man businesses come to mind.
Businesses that have a strong track record, repeat clients, historical pattern of growth, more than 3 years in business, perhaps some proprietary item, a large customer base, or an exclusive territory, a growing industry, etc., will sell in the three-times ratio (and sometimes more). The others fall somewhere in-between.
The Rules To Apply To Establish A Multiple
The most important part of valuations is to consider this as two pieces to a puzzle. Part one is easy because it deals with the numbers and numbers don't lie (people do, and sellers especially do, but the numbers are the numbers!) You will use the historical financials to establish the Owner Benefit figure for each of the last three years or more.
Next, a weighted average must be applied to arrive at an "Average Owner Benefit" figure.
That's the first part.
The second part is to establish the actual multiple. To do so, you need to consider the fundamentals of the business, the years it has been around, the competition, the suppliers, the lease terms, the strength of the customers, the conditions of the assets, how easily the business will transition to a new owner, will customers continue to buy from you, and on and on the list goes. In other words, this part is really measuring the core of the business outside of the numbers.
Establishing the multiple is the most important aspect of the valuation exercise. It is also the part that traps most people who don't have a wealth of experience buying businesses. The good news is that with our guide, you also get access to a proprietary valuation spreadsheet that actually compiles the multiple and valuation for you. It is called the Diomo Business Assessment Method (DBA) and it was developed using over one thousand actual business investigations and valuations. It completes both pieces of the puzzle for you. All you do is enter the financials, answer some questions, and it does the rest of the work for you. (To read a review of The Diomo Business Assesment Method done by renowned valuation expert Ney Grant click here)
If You’re New At This, Here’s What To Do:
If you don’t know how to read an income statement, then learn. It’s crucial if you want to be successful in this process. Learning how to read and analyze statements is simple, and can be done quickly. Lesson # 11 in our guide will take you through this entire exercise and within an hour you will know how to read financial statements.
Determine the true Owner Benefits of the business. Be careful about the add-backs. Make certain that any benefits being added back are not necessary expenses needed to run the business.
You can only add back something that has been expensed.
Calculate an accurate multiple based upon the business’ strengths and weaknesses.
If the business is right for you, it is all right to pay a slight premium, but not too drastically overpay. Keep in mind as we teach in the course section on negotiating the deal, the value is often in the terms you get, not necessarily the price you pay.
Consider applying other valuation formulas simply as a test to your figure.
Professional Valuations: Do You Need One?
For most small businesses, hiring a professional to perform a valuation is not necessary. First of all it is expensive, and more often than not, it simply does not reflect reality. I read a valuation recently on a local company handling specialized telecom components in a very restricted marketplace doing $700,000 a year in sales and netting $100,000. The valuation started off: “The company is focused upon the B2B telephony segment which is a $42 billion industry in North America.”
I threw out the entire report after reading that one sentence. Why? How on earth can you possibly compare a $42-billion dollar industry and a $700,000 local distributor of telephone systems? Don’t waste time or money getting a professional valuation done. Let the seller do that if they so choose.
The Final Word: Accurately valuing a business is obviously a critical component to the business buying process. However, you always want to be certain that the business is right for you, not simply priced right. Knowing how to compile a valuation will not only assure you of paying the right price, but it will also demonstrate your knowledge when seeking financing for the deal. To eliminate the guesswork, make certain you use the automated valuation spreadsheets in the program How To Buy A Good Business At A Great Price©.
http://www.diomo.com/valuing-a-business.html
By Richard Parker: President of The Business Buyer Resource Center and author of How To Buy A Good Business At A Great Price ©
Accurately valuing a small business is often the most challenging part of the process for prospective business buyers. However, it doesn’t have to be an overwhelming or difficult undertaking. Above all, you should realize that valuation is an art, not a science. As a buyer, always keep in mind that the “Asking Price” is NOT the purchase price. Quite often it does not even remotely represent what the business is truly worth.
Naturally, a buyer’s valuation is usually quite different from what the seller believes their business is worth. Sellers are emotionally attached to their businesses. They usually factor their years of hard work into their calculation. Unfortunately, this has no business whatsoever being in the equation.
The challenge for you, the buyer, is to formulate a valuation that is accurate, and will prove to provide you with an acceptable return on your investment.
There are several ways to calculate the value of a business:
Asset Valuations: Calculates the value of all of the assets of a business and arrives at the appropriate price.
Liquidation Value: Determines the value of the company’s assets if it were forced to sell all of them in a short period of time (usually less than 12 months).
Income Capitalization: Future income is calculated based upon historical data and a variety of assumptions.
Income Multiple: The net income (profit/owner's benefit/seller's cash flow) of a business is subject to a certain multiple to arrive at a selling price.
Rules Of Thumb: The selling price of other “like” businesses is used as a multiple of cash flow or a percentage of revenue.
Asset-based valuations do not work for small business purchases. Assets are used to generate revenue and nothing more. If a business is "asset rich" but doesn't make much money, how valuable is the business altogether? Conversely, if a business has limited assets, such as computers and office equipment, but makes a ton of money, isn't it worth more?
Income Capitalization is generally applicable to large businesses and most often uses a factor that is far too arbitrary.
"The key to making good decisions in life is education. There has always been a void in effective buyer educational tools until the course How To Buy A Good Business At A Great Price came along."
The “Rule of Thumb” method is too general. It's hard to find any two businesses that are exactly the same. Valuation must be done based upon what you, as the buyer, can reasonably expect to generate in your pocket, so long as the business’ future is representative of the past historical financial data.
The Multiple Method is clearly the way to go. You have probably heard of businesses selling at “x times earnings”. However, this can be quite subjective because earnings can actually mean different things in different businesses. When buying a small business, every buyer wants to know how much money he or she can expect to make from the business. Therefore, the most effective number to use as the basis of your calculation is what is known as the total “Owner Benefits”.
Note: You will come across different terms on various websites and in business for sale profiles for Owner's Benefit such as Seller's Discretionary Earnings, Adjusted Earnings, and others as well. Make certain that the seller provides you with the exact formula of how they arrived at this figure - this is critical.
The Owner Benefit amount is the total dollars that you can expect to have available from the business (based upon the past financials) to pay yourself a salary, service any debt, and marklet the business assuming that everything remains status quo after you take over. The beauty is that unlike other methods (i.e. Income Cap), it does not attempt to predict the future. Nobody can do that.
(Very Important: Owner's Benefit is not cash flow and cash flow is not profit. Cash Flow is probably the most misunderstood and misused accounting term. Cash Flow is simply the amount of cash a business had at the beginning of a period, how much it had at the end of a period and what happened in between to it.)
The theory behind the Owner Benefit number is to take the business’ profits plus the owner’s salary and benefits and then to add back the non-cash expenses. History has shown that this methodology, while not bulletproof, is the most effective way to establish the valuation basis of a small business. Then, a multiple, based upon a variety of factors, is applied to this number and a valuation is established.
The Owner Benefit formula to use is:
Pre-Tax Profit + Owner’s Salary + Additional Owner Perks + Interest + Depreciation LESS Allowance for Capital Expenditures
Why Add Back Depreciation?
Depreciation is an expense that allows a business to deduct a certain amount of money each year from an asset so that its purchase value is reduced by its overall useful life. As an example: if the business buys a $25,000 truck and its useful life is estimated at 5 years, then each year the company can deduct $5000 off its income to lessen its tax burden. However, as you can see, it is not an actual cash transaction. No money is physically leaving the business or changing hands. Therefore, this amount is added back.
Why Add Back Interest?
Each business owner will have separate philosophies for borrowing for the business and how to best use borrowed funds, if necessary at all. Furthermore, in nearly all cases, the seller will pay off the business’ loans from their proceeds at selling; therefore, you will have use of these additional funds.
A Note About Add-Backs (Capital Expenditure Allowance)
After completing any add-backs, it is critical that you take into consideration the future capital requirements of the business as well as debt-service expenses. As such, in capital-intensive businesses where equipment needs replacing on a regular basis, you must deduct appropriate amounts from the Owner Benefit number in order to determine both the true value of the business as well as its ability to fund future expenditures. Under this formula, you will arrive at a "net" Owner Benefit number or true Free Cash Flow figure.
"I've just completed the purchase of an established business with a 30-year history, now retiring its second owner. Your guide was perfect in helping me select this business, especially in assessing its value. Thanks again for your personal attention to my purchase and pursuits."
Gil Takemori - San Jose, CA
What Multiple?
Typically, small businesses will sell in a one to three-times multiple of this figure. Now, this is a wide range, and some businesses will sell for more, so how do you determine what to apply? The best general rule to keep in mind und is that a one-time multiple is for those businesses where the seller is “the business”. In other words: "as out the door goes the seller, so too can go the customers". Consulting businesses, professional practices, and one-man businesses come to mind.
Businesses that have a strong track record, repeat clients, historical pattern of growth, more than 3 years in business, perhaps some proprietary item, a large customer base, or an exclusive territory, a growing industry, etc., will sell in the three-times ratio (and sometimes more). The others fall somewhere in-between.
The Rules To Apply To Establish A Multiple
The most important part of valuations is to consider this as two pieces to a puzzle. Part one is easy because it deals with the numbers and numbers don't lie (people do, and sellers especially do, but the numbers are the numbers!) You will use the historical financials to establish the Owner Benefit figure for each of the last three years or more.
Next, a weighted average must be applied to arrive at an "Average Owner Benefit" figure.
That's the first part.
The second part is to establish the actual multiple. To do so, you need to consider the fundamentals of the business, the years it has been around, the competition, the suppliers, the lease terms, the strength of the customers, the conditions of the assets, how easily the business will transition to a new owner, will customers continue to buy from you, and on and on the list goes. In other words, this part is really measuring the core of the business outside of the numbers.
Establishing the multiple is the most important aspect of the valuation exercise. It is also the part that traps most people who don't have a wealth of experience buying businesses. The good news is that with our guide, you also get access to a proprietary valuation spreadsheet that actually compiles the multiple and valuation for you. It is called the Diomo Business Assessment Method (DBA) and it was developed using over one thousand actual business investigations and valuations. It completes both pieces of the puzzle for you. All you do is enter the financials, answer some questions, and it does the rest of the work for you. (To read a review of The Diomo Business Assesment Method done by renowned valuation expert Ney Grant click here)
If You’re New At This, Here’s What To Do:
If you don’t know how to read an income statement, then learn. It’s crucial if you want to be successful in this process. Learning how to read and analyze statements is simple, and can be done quickly. Lesson # 11 in our guide will take you through this entire exercise and within an hour you will know how to read financial statements.
Determine the true Owner Benefits of the business. Be careful about the add-backs. Make certain that any benefits being added back are not necessary expenses needed to run the business.
You can only add back something that has been expensed.
Calculate an accurate multiple based upon the business’ strengths and weaknesses.
If the business is right for you, it is all right to pay a slight premium, but not too drastically overpay. Keep in mind as we teach in the course section on negotiating the deal, the value is often in the terms you get, not necessarily the price you pay.
Consider applying other valuation formulas simply as a test to your figure.
Professional Valuations: Do You Need One?
For most small businesses, hiring a professional to perform a valuation is not necessary. First of all it is expensive, and more often than not, it simply does not reflect reality. I read a valuation recently on a local company handling specialized telecom components in a very restricted marketplace doing $700,000 a year in sales and netting $100,000. The valuation started off: “The company is focused upon the B2B telephony segment which is a $42 billion industry in North America.”
I threw out the entire report after reading that one sentence. Why? How on earth can you possibly compare a $42-billion dollar industry and a $700,000 local distributor of telephone systems? Don’t waste time or money getting a professional valuation done. Let the seller do that if they so choose.
The Final Word: Accurately valuing a business is obviously a critical component to the business buying process. However, you always want to be certain that the business is right for you, not simply priced right. Knowing how to compile a valuation will not only assure you of paying the right price, but it will also demonstrate your knowledge when seeking financing for the deal. To eliminate the guesswork, make certain you use the automated valuation spreadsheets in the program How To Buy A Good Business At A Great Price©.
http://www.diomo.com/valuing-a-business.html
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