Valuing A Business
Leith Oliver
Thinking of buying a business? Leith Oliver helps you to calculate what it might be worth to you, and offers some thoughts on franchise fees and goodwill payments.
In New Zealand, the proportion of small business ownership has always been high. However, it is only relatively recently that the idea of owning your own business through buying a franchise has come to the fore.
Despite the success of many franchise systems both in NZ and overseas, there still exist some misunderstandings and even suspicion about franchising on the part of prospective purchasers. If you buy an existing business you can look at the outlet or the plant, look at the trading history, see real figures and real customers. But if you buy the rights to set up a franchise in a new territory, doesn't it seem a lot of money to pay for something which doesn't even exist yet?
In any existing business, the seller will ask an often substantial amount of money for an item called "goodwill" – the factor which assumes that because the business has an established client base, they will keep on coming when the new owner takes over. There is certainly merit in this concept, but I have seen many cases where goodwill figures of $30-50,000 have been asked when the real value of the business has been nowhere near the total amount asked.
The problem for any prospective purchaser, whether of an independent business or of a franchise, is to know what it is really worth. I would like to suggest a way of working this out, and to look at how you can apply this process to evaluating a franchise.
From a purchaser's point of view, buying a business is an investment decision. Like any other investment decision, the value of the investment is based upon the returns available from it. Where you are purchasing a business, the returns are represented by the trading profits, and so the purchaser is mostly interested in the value of the available profits that the business can generate.
Of course, in a new start-up business (such as a franchise), there may be a particularly important element of capital gain to be considered as well.
What do you value?
When a business is offered for sale, the seller will ask a price based on the values of various assets. The most obvious of these are the tangible assets of the business – the plant and equipment used to run the business, and the stocks of goods that are traded. In many cases, other intangible assets are also included in the asking price. These may include goodwill, branding and trademarks, and manufacturing or trading licences.
Although they are the most obvious of the items to be valued, establishing the true value of tangible assets is not straightforward. For example, should assets be valued at book value (the value they have in the business's accounts) or at market value (the price you would get for them if you sold them tomorrow)? Computer equipment is a case in point. If the business paid $5000 for a computer system last year, it might still be worth $3300 on the company's books – but who would buy an out-of-date computer for that much money?
Ultimately, the price for the assets is a matter of negotiation between buyer and seller. If the value of the assets is set at a higher level, then the buyer benefits from future available tax write-offs. If the assets are valued low in the purchase transaction, this benefits the seller through current tax write-offs.
Another question to ask about tangible assets is: "Are they the right assets? Are they the right type and quality, and is there the right amount?" If the assets are inadequate, then extra funds will be needed quickly to get the business functioning properly. Alternatively, if too much money is tied up in inefficient assets then the business returns will be poor. When you buy a franchise, you know that you will be getting the benefits of the franchisor's experience to ensure that you buy the right equipment and the right stock to start up with.
Intangible assets
From a purchaser's point of view, the intangibles such as goodwill and branding present an even greater difficulty in valuation because the values used may be discretionary and subjective – they may be just what the seller thinks they are worth, and may have no foundation in reality.
On the one hand, the fact that they add value to the business is obvious – but how much value? On the other hand, what happens if the business doesn't do well and the assets need to be sold – will these intangible assets have any value then? A good franchise brand will – an independent name won't.
These questions are all hard to answer, and generally mean that a purchaser should not use asset values directly in establishing a purchase price for the business.
Valuing the profits
To my mind, valuing the profits is the solution to the problem of valuing a business. If we regard the purchase of a business as an investment, then the true value can be established by valuing the profits that result from its operation in a given business environment. This method takes the business as a total operational unit and values its ability to produce returns for the shareholders.
The following outlines how to value a business by capitalising the net profit.
Every investment has three components:
1 The dollar amount invested
2. The dollars returned from the investment.
3. The return expressed as an interest rate received on the investment.
These form a simple equation:
The Investment x The Interest Rate = The Return
Eg, an Investment of $20,000 at 10% Interest Rate would give a return of $2,000. And, rearranged, you can say
The Investment = The Return ÷ The Interest Rate.
When purchasing a business, we want to calculate what the Investment value (ie, the price) should be. Using the equation above, we can calculate the maximum total price that the business is worth to us as an investor if we know:
i) the annual dollar return figure, and
ii) what we expect as an interest rate on our investment.
Establishing the annual return
The first of these, the annual dollar return figure, is the figure for Net Profit Before Interest & Tax (NPBIT). Note that the interest cost is excluded because it relates to the borrowing needs of the owner – not the business.
This figure will be provided by the seller either from past trading records or from budgets of future trading figures (in the case of new start-up franchise businesses, actual figures may be provided from the trading histories of existing franchises or a pilot operation). It is up to the buyer to satisfy themselves that the expected future profits are reliably represented in the valuation process.
The NPBIT figure represents Total Sales Income minus Total Costs. In most cases, the business costs are easily identified and future predictions can be checked for validity with some certainty. Note that a reasonable salary for the owner/manager must be included as one of the operating costs (not all businesses show this).
The Total Sales Income, however, is a different story. Many complex factors influence the future sales revenue of any business. Changes in the economy, increased competition, new regulations and shifting markets, along with the unknown performance of a new owner, all mean that sales predictions suffer from a high degree of uncertainty (and much more with an independent business than a franchise). For this reason, it becomes the buyer's responsibility to make their own forecast of future sales, using the seller's figures as a starting point only, and then moderating those to arrive at a conservative prediction.
Note, however, that when you are dealing with a reputable and well-established franchise, they will be basing their projections on a substantial amount of data, and will often already be providing cautious figures. Beware of revising these down again to the point where an obviously sound proposition begins to look unprofitable!
When the buyer is satisfied that the sales and cost figures are realistic, the NPBIT can be calculated for use in the next process.
Establishing the Required Rate of Return
The Required Rate of Return (RRR) is tied to one main business factor – risk. This marriage between RRR and risk is all around us in the commercial world. An investment in Government Bonds gives low interest because the commercial risk is low. Placing your money in an investment account with the local Savings Bank pays a little more because the risk has increased slightly. In contrast, investing on the stock market carries much higher risk and therefore investors expect much higher rates of return. Credit card companies give you an unsecured loan each time you use your card, and consider the risk to be high enough to warrant the current interest charge of around 20%.
The question is: "What rate reflects the risk of investing in a small business?" In this case, the RRR must take account of two risk factors:
i) the financial market rate for an unsecured small business investment, and
ii) the unique risk attached to a particular purchase situation.
A quick check with finance brokers suggests that the current market rate for small business investment risk is about 33%. Add to this an allowance for unique risk factors (eg. short trading history, lack of reliable figures, seasonal business, aggressive competition, etc) and you could easily have a RRR on the purchase of 40% or more.
Alternatively, the risk might be reduced by circumstances (eg. the vendor leaving money in the business or remaining associated with it, the presence of some unique competitive advantage, forward contracts assuring future sales revenues, etc.). In this case the RRR may reduce to somewhere below 30%.
Whatever factors are present, the point is that the buyer must take responsibility for establishing a RRR that they believe compensates them for the business risk they are taking.
An example
Last year I was asked by a prospective purchaser to help in valuing a business that distributes machine parts to the crop harvesting industry. The business was being offered for sale as follows:
Sales $200,000pa
Price:
Vehicles and Other Plant $30,000
Goodwill $25,000
Stock $65,000
Total $120,000
After analysing the trading accounts for the past three years, we established that the NPBIT had been reliable and consistent at about $30,000 per year. Independent valuations on the assets verified the value of the plant at $30,000 and stock at $65,000. The seller was prepared to leave some money in the business and would also remain associated with the business as a supplier. These factors acted to reduce the risk but were more than offset by another concern. The crop harvesting industry is very dynamic and unpredictable. Its fortunes are governed by weather, the volume of growing contracts from the food processing industry, and fluctuating market prices for produce. Because of the variability and riskiness of the industry we decided that an RRR of 35% was an appropriate reflection of the purchase risk.
The amount my client was willing to offer for the business could now be established using the equation introduced earlier:
The Investment
= The Return ÷ RRR
= $30,000 ÷ 35%
= $85,714
With reference to the original asking price of $120,000, my client's eventual offer of $86,000 was in fact saying "given the riskiness of the venture there is not enough net profit to generate a goodwill figure, and there is probably too much stock being carried relative to the trading performance of the business."
Note that if we had used another RRR the result would have been different. A 30% RRR, for example, would have given the following result:
Investment
= $30,000 ÷ 30%
= $100,000
The maximum price the buyer would pay with a RRR of 30% now has room for $5,000 of goodwill.
Five step process
The valuation process for a purchaser can thus be summarised as follows:
1. Establish a reliable estimate of the future sales.
2. Forecast the costs and expenses.
3. Calculate the resulting forecast of net profit before interest and tax.
4. Establish the required rate of return.
5. Calculate the value of the business by using the equation above to capitalise the expected future NPBIT.
A valuation that results in a figure less than the tangible asset value indicates operational inefficiency in the existing business, and eliminates any value for goodwill or other intangible assets. Conversely, if the valuation results in a figure that is higher than the tangible asset value, then the extra establishes the value of the intangible assets.
Are franchised business any different?
The example above shows what happens to the sale value of a business when the risk for the buyer is reduced. If the RRR used in the valuation calculation is reduced because of lower risk, then the maximum price a buyer is willing to pay increases. This has great significance for franchised businesses, because a good franchised business system includes many risk-reducing characteristics.
I group the risk reducing factors of franchised businesses into three types: those that support the system, the relationship between franchisor and franchisee, and marketing benefits. Some of the more obvious factors which reduce risk are given below:
1. Support Factors
There are a number of documents and procedures that have become standard items in well-developed franchise systems.
1. Good franchisors issue disclosure documents to purchasers of franchises. The disclosure document gives background information on the identity, financial health and viability of the franchisor.
2. The franchise agreement sets out in detailed form, the responsibilities and authorities of both parties. In the final analysis it is an insurance policy for both sides and helps the business system to run smoothly and effectively.
3. In established franchises a proven business system has been developed and documented in a set of operational manuals. The manuals provide a clear operational path and detailed methods and procedures that keep the business operator focused on producing efficient outputs and consistent quality.
4. Even in younger franchises in most cases pilot operations will have been run to test the system. These provide invaluable sets of operational information that help new operators to be successful and also provide sets of performance benchmarks that can be used for financial forecasting.
2. Relationship Factors
1. Franchising differs from other businesses at the time of a sale in that the franchisor, who is directly or indirectly involved in the sale, stays in an ongoing and often personal relationship with the new operator. The success of the franchisor and the franchisee are bound together in an interdependent relationship. It is in the franchisor's best interests that the franchisee is successful.
2. In addition, a franchise system is a family of businesses which together represent a pool of experience and knowledge. Support and learning from other franchisees is always available.
3. In most cases the relationship with the franchisor extends to ongoing training and management systems support. This improves the competency of new business operators and provides a system of in-house management advice and trouble shooting.
3. Marketing Factors
1. Franchised businesses have stronger branding and market presence. They are more visible in the marketplace due to multiple locations and regular advertising.
2. Combined marketing budgets enable the use of professional marketing services. Promotion and advertising are well planned and organised, and advertisements are professionally produced, giving stronger communication to the market.
3. Group purchasing factors enable franchised systems to buy at better rates and from a wider range of sources than individual businesses. Lower costs convert directly into competitive advantage over other businesses.
4. The impact of competitive activity and market changes is often reduced because the franchisor will be working on future developments all the time. Franchises often lead market changes rather than following them.
These three groups together will have a significant downward impact on the RRR used for valuation purposes (dropping the market rate to perhaps 20% in cases of a well managed franchise). This reduced risk helps to explain the higher economic value attached to franchised businesses.
By producing good financial results over a number of years and recording them in reliable accounting systems, the value continually improves. An investor who runs a franchised business efficiently stands to make a good capital gain on resale of the business, because strong recorded profits combined with low risk will make the business an attractive opportunity and maximise the selling price.
Value for money
One of the reasons people give for 'going it alone' rather than buying a franchise is because they resent paying a franchise fee – some comment that it is like paying goodwill for a business which hasn't got any customers yet.
But valuing assets, as we have seen, is a flawed process. If instead you use the procedure of capitalising NPBIT which looks at the whole performance of the business, you see a picture which more truly reflects the value of a proven franchise system.
If you look at the example I gave above and apply a RRR of 20% to the equation, it produces a value of $150,000 – or $55,000 goodwill. That figure is significantly higher, but reflects the lower risk of buying a franchise. Rather than goodwill, you might call it the franchise fee. And you might consider it a sum worth paying for a greater chance of success, because no matter how cheaply you buy a business, if it doesn't succeed you will lose your money.
At the end of the day, many will tell you that a business is worth what someone is prepared to pay for it. To some extent that is true, but as a prospective business purchaser it is up to you and your professional advisors to ensure that you do not pay more than the investment is worth to you. Buying a franchise can offer many significant advantages. The lesson to be learned from valuing businesses by their profitability is that theapparent 'additional' cost of a franchise fee may be worth every cent.
About the Author
Leith Oliver is a lecturer in management, small business and franchising at UNITEC Institute of Technology and at the University of Auckland
http://www.franchise.co.nz/article/view/82
Tuesday 10 November 2009
Why Value the Business?
Valuing a Business
1. Why Value the Business?
There are four main reasons for valuing a business.
1.1 To help you buy or sell a business.
Understanding the valuation process can help you to:
There is a better chance of a sale being completed if both the buyer and seller start with realistic expectations.
•Improve the business' real or perceived value.
•Choose a good time to buy or sell.
•Negotiate better terms.
•Complete a purchase more quickly.
1.2 To raise equity capital.
•A valuation can help you agree a price for the new shares being issued.
1.3 To create an internal market for shares.
•A valuation can help you to buy and sell shares in a business at a fair price.
1.4 To motivate management. Regular valuation is a good discipline. It can:
•Provide a measurement and incentive for management performance.
•Focus management on important issues.
•Identify areas of the business which need to be changed.
http://www.is4profit.com/business-advice/finance-and-money/valuing-a-business/why-value-the-business.html
1. Why Value the Business?
There are four main reasons for valuing a business.
1.1 To help you buy or sell a business.
Understanding the valuation process can help you to:
There is a better chance of a sale being completed if both the buyer and seller start with realistic expectations.
•Improve the business' real or perceived value.
•Choose a good time to buy or sell.
•Negotiate better terms.
•Complete a purchase more quickly.
1.2 To raise equity capital.
•A valuation can help you agree a price for the new shares being issued.
1.3 To create an internal market for shares.
•A valuation can help you to buy and sell shares in a business at a fair price.
1.4 To motivate management. Regular valuation is a good discipline. It can:
•Provide a measurement and incentive for management performance.
•Focus management on important issues.
•Identify areas of the business which need to be changed.
http://www.is4profit.com/business-advice/finance-and-money/valuing-a-business/why-value-the-business.html
Price/earnings ratio
5 Price/earnings ratio
The price/earnings ratio (P/E ratio) is the value of a business divided by its profits after tax.
Once you have decided on the appropriate P/E ratio to use (see below), you multiply the business’ most recent profits after tax by this figure. For example, using a P/E ratio of 5 for a business with post-tax profits of £100,000 gives a P/E valuation of £500,000.
5.1 P/E ratios are used to value businesses with an established, profitable history.
• P/E ratios vary widely
Multiple values
A small unquoted business is usually valued at between five and ten times its annual post-tax profit. Previously — most notably in the IT market — the ratio has exploded, with some valuations being drawn from multiples of 70 or more. However, the differential has closed significantly, with IT-based companies seeing the sharpest drops.
Following the so-called ‘correction’, commonly accepted earnings multiples to value quoted firms range from nine or ten to 25, although some exceptions remain.
5.2 Quoted companies have a higher P/E ratio. Their shares are much easier to buy and sell. This makes them more attractive to investors than shares in comparable, unquoted businesses.
• A typical P/E ratio for a large, growing quoted company with excellent prospects might be 20.
• Typically the P/E ratio of a small, unquoted company is 50 per cent lower than that of
a comparable quoted company in the same sector.
5.3 Compare your business with others.
• What are your quoted competitors’ P/E ratios? Newspapers’ financial pages give historic P/E ratios for quoted companies.
• What price have similar businesses been sold for?
5.4 P/E ratios are weighted by commercial conditions.
• Higher forecast profit growth means a higher P/E ratio.
• Businesses with repeat earnings are safer investments, so they are generally awarded higher P/E ratios.
5.5 Adjust the post-tax profit figure to give a true sustainable picture.
How to calculate profit
If you are considering buying a business, work out what the ‘true’ profitability is.
A Compare the owner’s stated profits with the audited figures.
• Question any differences.
B Look for costs which could be reduced under your ownership. For example:
• Consultancy fees.
• Payments to the owner and to other shareholders.
• Unnecessary property leases.
• Supplies — is there a cheaper supplier?
• Overlapping overheads.
C Look for areas to ‘restate’ (the accountancy term for changing a figure from one kind of cost to another). For example, money spent on software development may have been capitalised by the owner. You might consider that it should have been treated as a cost.
• Use your own accounting policies when calculating the business’ profits.
This will often result in a significantly different profit figure.
D When looking at future profits, bear in mind the costs of achieving them. These may include:
• Servicing increased borrowings.
• Depreciation of investment in plant, machinery, or new technology.
• Redundancy payments.
The arrival of new management often leads to major changes which may mean higher costs and lower productivity in the first year.
http://www.iod.com/intershoproot/eCS/Store/en/pdfs/cf1val.PDF
The price/earnings ratio (P/E ratio) is the value of a business divided by its profits after tax.
Once you have decided on the appropriate P/E ratio to use (see below), you multiply the business’ most recent profits after tax by this figure. For example, using a P/E ratio of 5 for a business with post-tax profits of £100,000 gives a P/E valuation of £500,000.
5.1 P/E ratios are used to value businesses with an established, profitable history.
• P/E ratios vary widely
Multiple values
A small unquoted business is usually valued at between five and ten times its annual post-tax profit. Previously — most notably in the IT market — the ratio has exploded, with some valuations being drawn from multiples of 70 or more. However, the differential has closed significantly, with IT-based companies seeing the sharpest drops.
Following the so-called ‘correction’, commonly accepted earnings multiples to value quoted firms range from nine or ten to 25, although some exceptions remain.
5.2 Quoted companies have a higher P/E ratio. Their shares are much easier to buy and sell. This makes them more attractive to investors than shares in comparable, unquoted businesses.
• A typical P/E ratio for a large, growing quoted company with excellent prospects might be 20.
• Typically the P/E ratio of a small, unquoted company is 50 per cent lower than that of
a comparable quoted company in the same sector.
5.3 Compare your business with others.
• What are your quoted competitors’ P/E ratios? Newspapers’ financial pages give historic P/E ratios for quoted companies.
• What price have similar businesses been sold for?
5.4 P/E ratios are weighted by commercial conditions.
• Higher forecast profit growth means a higher P/E ratio.
• Businesses with repeat earnings are safer investments, so they are generally awarded higher P/E ratios.
5.5 Adjust the post-tax profit figure to give a true sustainable picture.
How to calculate profit
If you are considering buying a business, work out what the ‘true’ profitability is.
A Compare the owner’s stated profits with the audited figures.
• Question any differences.
B Look for costs which could be reduced under your ownership. For example:
• Consultancy fees.
• Payments to the owner and to other shareholders.
• Unnecessary property leases.
• Supplies — is there a cheaper supplier?
• Overlapping overheads.
C Look for areas to ‘restate’ (the accountancy term for changing a figure from one kind of cost to another). For example, money spent on software development may have been capitalised by the owner. You might consider that it should have been treated as a cost.
• Use your own accounting policies when calculating the business’ profits.
This will often result in a significantly different profit figure.
D When looking at future profits, bear in mind the costs of achieving them. These may include:
• Servicing increased borrowings.
• Depreciation of investment in plant, machinery, or new technology.
• Redundancy payments.
The arrival of new management often leads to major changes which may mean higher costs and lower productivity in the first year.
http://www.iod.com/intershoproot/eCS/Store/en/pdfs/cf1val.PDF
****How much is your business worth?
How much is your business worth?
If you are thinking of selling up, what could you get for your business?
General Principals
The largest influence on the price you will get for your business is the Law of Supply & Demand. If, when you sell, there are plenty of buyers with ready cash and few sellers, you will get a good price. If the converse is true, you will either not get a good price or, even worse, you may find you cannot sell up.
Generally, people do not buy a business for what it is; they will buy for what the business does for them. Namely earn them cash to repay their investment, provide them with a living, and build for the future. With cash (not profits) uppermost in their mind on the first two of these, the price is often based on something called 'EBITDA'. EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortisation) is an accountancy term that represents the sustainable cash profits of the business assuming nil borrowing costs.
To value the business, a multiple is applied to EBITDA. The Law of Supply & Demand essentially dictates the multiple for a particular business sector, or any part of it, or any particular firm. There is no universally agreed multiple for a particular sector, or firm, and multiples vary widely between and within particular sectors depending on a number of factors, but principally the certainty and size of the future cash flows of the business. The multiple applied to your business will depend on a combination of factors, we go into some of these factors in detail below.
Pricing a business is thus more of an art than a precise science. It is not merely a calculation based on two predetermined numbers, and valuers, purchasers and vendors often arrive at differing figures. At the end of the day it is you who has to be satisfied that you have got the best deal under the circumstances.
To get the best price, the main issue you should concentrate on is timing. When the business is ripe for sale, it is often not the right time for you personally or there are too few purchasers with ready cash. All other permutations apply, except the one where all the circumstances fit together neatly. Consequently selling your business generally involves some form of compromise. This makes the decision more difficult for you, especially if you are emotionally tied to the business. There is always a lot going on in the business when you sell, negotiations are intense, and feelings high: selling is a stressful time for you. So it is important that you plan in advance how you are going to sell the business. Only by doing so will you maximise the price you will get. When planning, you should bear in mind the following:
Size
Forget the old maxim, size is important. Large firms attract bigger multiples and more interest than smaller firms because they are perceived as being less risky. Larger firms are less likely to fail and are less reliant on the owner's involvement. Your firm, however large it grows in its niche or how profitable it becomes, may be too small to attract the right purchaser, namely the one with cash. Thus ignore the price achieved for one of your larger, more inefficient, competitors: you may never achieve a similar multiple however good your business is.
Growth
Growth prospects are one of the more major factors affecting the multiple. Buyers will pay more for businesses with higher growth rates as they repay their initial investment quicker than those with low or no growth. Consider selling up before turnover or profits have levelled out. This may go against the grain where you have put in place the basis for such growth, but increasing the multiple, as opposed to increasing the EBITDA, will have a bigger impact on the price you achieve.
Profitability
High gross margins and good levels of cash generation from profits give buyers more flexibility going forward and reduce the risk of the investment proving bad. Buyers will pay more for businesses that consistently report better than industry average figures.
However, the fact that you operate an extremely tight ship may put a buyer off paying too high a price. Buyers will look for easy wins/cost savings, so if a buyer identifies areas where he can make large efficiency savings or growth that could make your company more valuable to him. It is often worthwhile specifically targeting potential purchasers able to achieve such synergies.
Sector
Some sectors attract better multiples than others. There are a number of reasons for this: fashion (such as the dot-coms, energy businesses etc); estimates as to future growth prospects; robustness at times of boom and bust etc. In general, the more certain the future cash flows of a sector, or company, the higher the multiple.
However, some niches within a sector can command a premium from time to time, depending on the then demand for the particular product/service. Building a 'sustainable competitive advantage' and 'Unique Selling Point(s)' in a small niche can produce a handsome price at a time of boom in that sector generally and a better than average price when times are bad.
Business Mix
Diversification, although often reducing operating risk, does not always add to value: it can reduce the value of the overall business. Buyers may only be willing to take on that part of your business that fits in well with theirs; they could either discount the overall price, leave you with the part they do not want or, in the worst case, you could find your business un-saleable. It may be safer to stay in a particular part of the sector, especially for smaller businesses, as it can be difficult to find a buyer who will appreciate diversity.
Customer Base
The quality of your customer base is one of the main factors influencing the multiple used. Customer bases made up of blue chip clients in growing industries attract higher multiples, particularly if there are opportunities for the buyer to sell additional services in to them. If specific customers, or customers in a particular industry, make up a large part of your business, it will affect your pricing, because buyers will see you as having too many eggs in one basket.
Other Factors
Another important component is the strength of the balance sheet. Once buyers have bought a business, they want to focus on growing it and integrating it into their own organisation, rather than deal with historic balance sheet problems.
Buyers will assess the former owner's management of working capital. Businesses with a history of good cash, debtor, and creditor management attract higher multiples than those with a poor track record.
Other balance sheet factors that can influence a firm's value such as the amount of bank / factor debt, and any impending litigation.
The Deal
It is important to many buyers to retain the owner, at least for a period of time, to help introduce them to customers and make sure staff are comfortable with the new regime.
Often a buyer will agree to pay an incentive (this is termed an 'earnout') to the owner to encourage him to stay and to seek to avoid bearing the entire risk of the acquisition. Buyers often look to pay the former owner a share of profits earned over a two or three year period.
Earnouts can constitute a major part of the purchase price. The smaller the company, the more uncertainties there are that could affect how the business might perform, and thus the more likely it is that the buyer will seek an earnout. With planning an exit taking up to two/three years, and the earnout a similar period, it could be five years before you can book your sun lounger fulltime.
Earnouts is one area where your advisers really earn their money. Earnouts create conflicting interests between the current and former owners of the business; there is a risk that the buyer will look to reduce or defer profits in order to minimise the earnout paid. The former owner will look to maximise profits and hasten their recognition. With the former owner having little or no influence post sale over strategy, accounting policies, expenditure etc, there is a very real risk that he could receive less than originally envisaged for the business. It is important that your advisers protect your position wherever possible.
There is a balancing act to be struck, you will have to decide how much money you are willing to wait for and form your own view of the risks involved based on the likely future profitability of the business and your assessment of the purchaser, as against accepting a lesser, but more certain, sum now.
Today's Market
At the end of the day, any business is only worth what you can get for it at the time you sell it. A mathematical calculation of value is a mere indication of potential worth, a discussion tool to be used during the negotiation process. Confidence levels set the level of demand for your business, and in turn how much purchasers may be willing to pay for it. Whilst any downturn will ultimately effect multiples, to get maximum value and increase the certainty of a sale, it is more important than ever that owners considering selling prepare and position their business ready for sale early, and that during the sale process is carried out in such a way as to target purchasers with the right fit, hunger and cash to complete a deal.
http://www.startinbusiness.co.uk/features/features/29_01_2003_biz_valuation.htm
If you are thinking of selling up, what could you get for your business?
General Principals
The largest influence on the price you will get for your business is the Law of Supply & Demand. If, when you sell, there are plenty of buyers with ready cash and few sellers, you will get a good price. If the converse is true, you will either not get a good price or, even worse, you may find you cannot sell up.
Generally, people do not buy a business for what it is; they will buy for what the business does for them. Namely earn them cash to repay their investment, provide them with a living, and build for the future. With cash (not profits) uppermost in their mind on the first two of these, the price is often based on something called 'EBITDA'. EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortisation) is an accountancy term that represents the sustainable cash profits of the business assuming nil borrowing costs.
To value the business, a multiple is applied to EBITDA. The Law of Supply & Demand essentially dictates the multiple for a particular business sector, or any part of it, or any particular firm. There is no universally agreed multiple for a particular sector, or firm, and multiples vary widely between and within particular sectors depending on a number of factors, but principally the certainty and size of the future cash flows of the business. The multiple applied to your business will depend on a combination of factors, we go into some of these factors in detail below.
Pricing a business is thus more of an art than a precise science. It is not merely a calculation based on two predetermined numbers, and valuers, purchasers and vendors often arrive at differing figures. At the end of the day it is you who has to be satisfied that you have got the best deal under the circumstances.
To get the best price, the main issue you should concentrate on is timing. When the business is ripe for sale, it is often not the right time for you personally or there are too few purchasers with ready cash. All other permutations apply, except the one where all the circumstances fit together neatly. Consequently selling your business generally involves some form of compromise. This makes the decision more difficult for you, especially if you are emotionally tied to the business. There is always a lot going on in the business when you sell, negotiations are intense, and feelings high: selling is a stressful time for you. So it is important that you plan in advance how you are going to sell the business. Only by doing so will you maximise the price you will get. When planning, you should bear in mind the following:
Size
Forget the old maxim, size is important. Large firms attract bigger multiples and more interest than smaller firms because they are perceived as being less risky. Larger firms are less likely to fail and are less reliant on the owner's involvement. Your firm, however large it grows in its niche or how profitable it becomes, may be too small to attract the right purchaser, namely the one with cash. Thus ignore the price achieved for one of your larger, more inefficient, competitors: you may never achieve a similar multiple however good your business is.
Growth
Growth prospects are one of the more major factors affecting the multiple. Buyers will pay more for businesses with higher growth rates as they repay their initial investment quicker than those with low or no growth. Consider selling up before turnover or profits have levelled out. This may go against the grain where you have put in place the basis for such growth, but increasing the multiple, as opposed to increasing the EBITDA, will have a bigger impact on the price you achieve.
Profitability
High gross margins and good levels of cash generation from profits give buyers more flexibility going forward and reduce the risk of the investment proving bad. Buyers will pay more for businesses that consistently report better than industry average figures.
However, the fact that you operate an extremely tight ship may put a buyer off paying too high a price. Buyers will look for easy wins/cost savings, so if a buyer identifies areas where he can make large efficiency savings or growth that could make your company more valuable to him. It is often worthwhile specifically targeting potential purchasers able to achieve such synergies.
Sector
Some sectors attract better multiples than others. There are a number of reasons for this: fashion (such as the dot-coms, energy businesses etc); estimates as to future growth prospects; robustness at times of boom and bust etc. In general, the more certain the future cash flows of a sector, or company, the higher the multiple.
However, some niches within a sector can command a premium from time to time, depending on the then demand for the particular product/service. Building a 'sustainable competitive advantage' and 'Unique Selling Point(s)' in a small niche can produce a handsome price at a time of boom in that sector generally and a better than average price when times are bad.
Business Mix
Diversification, although often reducing operating risk, does not always add to value: it can reduce the value of the overall business. Buyers may only be willing to take on that part of your business that fits in well with theirs; they could either discount the overall price, leave you with the part they do not want or, in the worst case, you could find your business un-saleable. It may be safer to stay in a particular part of the sector, especially for smaller businesses, as it can be difficult to find a buyer who will appreciate diversity.
Customer Base
The quality of your customer base is one of the main factors influencing the multiple used. Customer bases made up of blue chip clients in growing industries attract higher multiples, particularly if there are opportunities for the buyer to sell additional services in to them. If specific customers, or customers in a particular industry, make up a large part of your business, it will affect your pricing, because buyers will see you as having too many eggs in one basket.
Other Factors
Another important component is the strength of the balance sheet. Once buyers have bought a business, they want to focus on growing it and integrating it into their own organisation, rather than deal with historic balance sheet problems.
Buyers will assess the former owner's management of working capital. Businesses with a history of good cash, debtor, and creditor management attract higher multiples than those with a poor track record.
Other balance sheet factors that can influence a firm's value such as the amount of bank / factor debt, and any impending litigation.
The Deal
It is important to many buyers to retain the owner, at least for a period of time, to help introduce them to customers and make sure staff are comfortable with the new regime.
Often a buyer will agree to pay an incentive (this is termed an 'earnout') to the owner to encourage him to stay and to seek to avoid bearing the entire risk of the acquisition. Buyers often look to pay the former owner a share of profits earned over a two or three year period.
Earnouts can constitute a major part of the purchase price. The smaller the company, the more uncertainties there are that could affect how the business might perform, and thus the more likely it is that the buyer will seek an earnout. With planning an exit taking up to two/three years, and the earnout a similar period, it could be five years before you can book your sun lounger fulltime.
Earnouts is one area where your advisers really earn their money. Earnouts create conflicting interests between the current and former owners of the business; there is a risk that the buyer will look to reduce or defer profits in order to minimise the earnout paid. The former owner will look to maximise profits and hasten their recognition. With the former owner having little or no influence post sale over strategy, accounting policies, expenditure etc, there is a very real risk that he could receive less than originally envisaged for the business. It is important that your advisers protect your position wherever possible.
There is a balancing act to be struck, you will have to decide how much money you are willing to wait for and form your own view of the risks involved based on the likely future profitability of the business and your assessment of the purchaser, as against accepting a lesser, but more certain, sum now.
Today's Market
At the end of the day, any business is only worth what you can get for it at the time you sell it. A mathematical calculation of value is a mere indication of potential worth, a discussion tool to be used during the negotiation process. Confidence levels set the level of demand for your business, and in turn how much purchasers may be willing to pay for it. Whilst any downturn will ultimately effect multiples, to get maximum value and increase the certainty of a sale, it is more important than ever that owners considering selling prepare and position their business ready for sale early, and that during the sale process is carried out in such a way as to target purchasers with the right fit, hunger and cash to complete a deal.
http://www.startinbusiness.co.uk/features/features/29_01_2003_biz_valuation.htm
How To Value A Business
How To Value A Business
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.
Let's look at each to determine what's best for your purchase:
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 "Rule of Thumb" method may be too general since 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's future is representative of the past historical financial data. Notwithstanding this, the "Rules of Thumb" methodology is an good place to start but is a bit too broad to consider by itself.
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. 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."
The Owner Benefits amount is the total dollars that you can expect to extract or have available from the business based upon what the business has generated in the past. The beauty is that unlike other methods (i.e. Income Cap), it does not attempt to predict the future. Nobody can do that. Owner Benefit is not cash flow! It is, however, sometimes referred to as Seller's Discretionary Cash Flow (SDCF).
The theory behind the Owner Benefit number is to take the business's 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 Allocation 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's loans from their proceeds at selling; therefore, you will have use of these additional funds.
A Note About Add-Backs
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 fund future expenditures. Under this formula, you will arrive at a "net" Owner Benefit number or true Free Cash Flow figure.
What Multiple?
Typically, small businesses will sell in a one-to three-times multiple of this figure. Now, this is a wide range, so how do you determine what to apply? The best mechanism I have found 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, or an exclusive territory, a growing industry, etc., will sell in the 3-times ratio. The others fall somewhere in-between.
So now the big question: what number/multiple do you apply to the Owner's Benefit number? The answer is simple: nearly all small businesses will sell in the 1-to-3 times Owner Benefit window. Of course, this is a very wide range.
Also, the actual total Owner Benefit figure will impact the multiplier. As the Owner Benefit number increases, so too will the multiple. As an example, a business generating $200,000 in OB, may be worth a 3 times multiple, but one generating $500,000 or $1,000,000 can be worth a four or five times multiple.
The Rules to Apply To Establish A Multiple:
You also want to calculate the Return on Investment (ROI) that you can expect to achieve when buying a business. Let's say that you have $100,000 for a down payment. If you go to Las Vegas and let it rip on "17 black," well you should be entitled to enormous odds. Wouldn't you agree? On the other hand, if you invest it in commercial real estate, which is a solid, stable investment, then 10% return on your money seems about right, doesn't it? In fact, when the real estate market heats up, the return cvan diminish to 5% or so, and still investors are satisfied.
Buying a business is clearly a greater "risk" but definitely far less than gambling it at a casino and so you should expect something in-between. I've always felt that a 25% return on your investment should be the minimum and you can, if negotiated well, get as high as 35% -50% ROI.
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 important for this process. It's simple, and can be done quickly.
Work with your accountant, if necessary, to 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 a multiple in the 1-3-times window based upon the business's strengths and weaknesses. Note that the multiple will increase along with the Owner benefit figure.
Determine your investment level and an acceptable ROI.
Understand that value is personal.
If the business is right for you, it is all right to pay a slight premium, but not to drastically overpay.
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 specialized B2B telephony arena and operates within a broad industry which generates annual revenues of $42 billion in North America. Leading competitors include Nortel, Cisco….." 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 for a small business acquisition. Let the seller do that if they so choose. If you want to look at a variety of scenarios, there are some very good, inexpensive software packages available that will do the same thing at a fraction of the cost.
The Key Points:
Remember that valuations are not scientifically based; they're subjective.
Use a variety of methods.
Owner Benefits is the number on which to base your multiple
Uncover how the seller established the asking price
Valuation is a personal formula - What's the business worth to YOU?
Consider the potential return on your cash investment
Final Word: Never, ever buy a business just because the price is right - first and foremost be certain that the business itself is right for you!
About the Author
Richard Parker is the author of How To Buy A Good Business At A Great Price ©, the most widely used reference resource and strategy guide for buying a business. This comprehensive simple to follow guide contains 420 pages of expert tips, proven strategies and winning negotiating techniques. Mr. Parker has purchased ten small businesses in the past 14 years. As President and founder of Diomo Corporation - The Business Buyer Resource Center, his materials have helped thousands of prospective small business buyers realize their dream of business ownership (click here to read some of their stories). His programs are sold in over 50 countries. Available in hard copy or via immediate electronic download. To order a copy click here. Review the complete course outline.
http://buying.businessmart.com/how-to-value-a-business.php
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.
Let's look at each to determine what's best for your purchase:
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 "Rule of Thumb" method may be too general since 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's future is representative of the past historical financial data. Notwithstanding this, the "Rules of Thumb" methodology is an good place to start but is a bit too broad to consider by itself.
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. 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."
The Owner Benefits amount is the total dollars that you can expect to extract or have available from the business based upon what the business has generated in the past. The beauty is that unlike other methods (i.e. Income Cap), it does not attempt to predict the future. Nobody can do that. Owner Benefit is not cash flow! It is, however, sometimes referred to as Seller's Discretionary Cash Flow (SDCF).
The theory behind the Owner Benefit number is to take the business's 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 Allocation 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's loans from their proceeds at selling; therefore, you will have use of these additional funds.
A Note About Add-Backs
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 fund future expenditures. Under this formula, you will arrive at a "net" Owner Benefit number or true Free Cash Flow figure.
What Multiple?
Typically, small businesses will sell in a one-to three-times multiple of this figure. Now, this is a wide range, so how do you determine what to apply? The best mechanism I have found 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, or an exclusive territory, a growing industry, etc., will sell in the 3-times ratio. The others fall somewhere in-between.
So now the big question: what number/multiple do you apply to the Owner's Benefit number? The answer is simple: nearly all small businesses will sell in the 1-to-3 times Owner Benefit window. Of course, this is a very wide range.
Also, the actual total Owner Benefit figure will impact the multiplier. As the Owner Benefit number increases, so too will the multiple. As an example, a business generating $200,000 in OB, may be worth a 3 times multiple, but one generating $500,000 or $1,000,000 can be worth a four or five times multiple.
The Rules to Apply To Establish A Multiple:
You also want to calculate the Return on Investment (ROI) that you can expect to achieve when buying a business. Let's say that you have $100,000 for a down payment. If you go to Las Vegas and let it rip on "17 black," well you should be entitled to enormous odds. Wouldn't you agree? On the other hand, if you invest it in commercial real estate, which is a solid, stable investment, then 10% return on your money seems about right, doesn't it? In fact, when the real estate market heats up, the return cvan diminish to 5% or so, and still investors are satisfied.
Buying a business is clearly a greater "risk" but definitely far less than gambling it at a casino and so you should expect something in-between. I've always felt that a 25% return on your investment should be the minimum and you can, if negotiated well, get as high as 35% -50% ROI.
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 important for this process. It's simple, and can be done quickly.
Work with your accountant, if necessary, to 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 a multiple in the 1-3-times window based upon the business's strengths and weaknesses. Note that the multiple will increase along with the Owner benefit figure.
Determine your investment level and an acceptable ROI.
Understand that value is personal.
If the business is right for you, it is all right to pay a slight premium, but not to drastically overpay.
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 specialized B2B telephony arena and operates within a broad industry which generates annual revenues of $42 billion in North America. Leading competitors include Nortel, Cisco….." 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 for a small business acquisition. Let the seller do that if they so choose. If you want to look at a variety of scenarios, there are some very good, inexpensive software packages available that will do the same thing at a fraction of the cost.
The Key Points:
Remember that valuations are not scientifically based; they're subjective.
Use a variety of methods.
Owner Benefits is the number on which to base your multiple
Uncover how the seller established the asking price
Valuation is a personal formula - What's the business worth to YOU?
Consider the potential return on your cash investment
Final Word: Never, ever buy a business just because the price is right - first and foremost be certain that the business itself is right for you!
About the Author
Richard Parker is the author of How To Buy A Good Business At A Great Price ©, the most widely used reference resource and strategy guide for buying a business. This comprehensive simple to follow guide contains 420 pages of expert tips, proven strategies and winning negotiating techniques. Mr. Parker has purchased ten small businesses in the past 14 years. As President and founder of Diomo Corporation - The Business Buyer Resource Center, his materials have helped thousands of prospective small business buyers realize their dream of business ownership (click here to read some of their stories). His programs are sold in over 50 countries. Available in hard copy or via immediate electronic download. To order a copy click here. Review the complete course outline.
http://buying.businessmart.com/how-to-value-a-business.php
Monday 9 November 2009
Valuing a Business
Valuing a Business
Last updated: 7/11/2008 View printable version
Selling your business will probably be the largest financial transaction you will ever undertake. Getting the right price is crucial.
You will have worked hard over years, maybe even decades, to build a successful company, and will want to maximise the amount you receive; realising its full value will be the ultimate reward for all your hard work and dedication.
And going into a potential deal with an idea of the figure you expect to negotiate enable you to manage the process far more effectively.
Before thinking about approaches to the so-called ‘art’ of valuation, you should consider your reasons for selling. Most advisors recommend formulating an ‘exit strategy’ before you even start a business; selling it when you have achieved your objectives, financial or otherwise, is the most common route.
Selling for the right reasons
Although many business owners continue driving forward well beyond their planned exit point, it’s worth remembering the old maxim: “it’s better to sell out than burn out.” Why not cash in while you are still young and healthy and enjoy the proceeds from all your hard work?
But even in a successful business, a sale can be precipitated by other factors – personal problems, for example, or disagreements among partners or directors. You might receive an unsolicited approach from a company, offering unimaginable amounts of cash for your business. More commonly, you might realise that the current economic climate is ideal for a seller – and not necessarily because of any wider indicators (unheard of purchase prices for similar companies, for example).
Too many sellers choose to exit when their business enters a downturn, when the value of their business looks lower to vendors. In an ideal world, you should aim to sell when your business looks set for growth: when turnover and profit is up, and when buyers will be desperate to get a share of the action.
Of course, some businesses are sold because the owner feels they are unsuccessful or are likely to become so in the future – but this doesn’t mean they are worthless. The right vendor – one that knows the sector – could find a business like this more attractive than a thriving one, because he or she might have the capital or resources to provide the missing link that would trigger growth and quickly boost its value. Even if a company isn’t a ‘cash cow’, it will, in most cases, have some form of assets, real or otherwise, that will represent value to the right buyer.
Valuation is an art, not a science
Understanding the valuation process will allow you to understand the ‘mind’ of that buyer. It will also help you to maximise the value of the business – by realising what you need to do to prepare a business for sale.
Many commentators claim valuation is an art, not a science. Renowned financial journalist Michael Brett once quipped that, in that case, it is the only form of art that regularly appears on company balance sheets.
What is really meant by this phrase is that valuation involves a lot of guesswork and lateral thinking. There is no ‘right’ figure – it could be worth half as much to one buyer as another. If your main product is a widget and demand suddenly surges in Brazil, this ratio could be one to three, or one to 10 if investment bankers have suddenly decided to take an interest in your sector.
If you are selling a house, valuers can use the sale price of other houses in the same street that were sold recently to reach a figure. But this method does not work well in valuing a business: it is highly unlikely that one with the same number of employees in the same part of the country will have been sold within the past month or so.
Valuations, even when carried out by experienced corporate financiers, can go horribly wrong – for example, Ford bought Kwik-Fit for £1bn in 1999, only to sell it for less than half the price three years later. Conversely, there are a host of examples of stock market analysts criticising acquisitions that subsequently outperform all expectations.
Nevertheless, there are four ‘models’ you should consider using to estimate the right price for your business:
Throughout the process, you will need to bear in mind what ‘components’ your business has: the assets it owns, the goodwill it has with customers and suppliers, and the expertise of its employees.
The asset-based approach is the most conservative of all valuation models. It is appropriate for businesses such as property companies or manufacturers, where assets form a large percentage of the ‘worth’ of the business (in the former case, buildings or development sites; in the latter case, expensive tools or machines). This method gives you a rough idea of the minimum price you can expect to negotiate – a financial comfort blanket.
To use this method, you simply add up the value of your assets and subtract any liabilities. Using the figures in your accounts – the net book value – is a good starting point, but remember that accountants are obliged to be prudent; they must give the minimum the assets could be sold for.
You will need to adjust those figures to reflect changing circumstances and market value. For example, have assets gone up in value? Or would they be difficult to dispose of, whatever the original cost? Has your accountant exaggerated the possibility of bad debts? In your calculation of liabilities, remember to include the company’s obligations – for example, rent or redundancy payments.
Price/earnings ratio
The price/earnings ratio is usually the most familiar valuation method to people with a modicum of business knowledge. It’s the most common way that analysts compare the values of companies quoted on the stock exchange. It’s not always appropriate for smaller, unlisted businesses as it can only really represent the value of established companies with a history of steady profit.
A value is determined using this method by dividing the market value per share by the post-tax earnings per share. So if the value of a single share on the stock market is 100p and the post-tax earnings per share are 5p, then the price/earnings ratio is 20. This means then that the business will be valued at 20p for each 1p of current earnings. So the higher the ratio, the higher the value you place on the business.
According to the Institute of Directors (IoD), a small unquoted business is usually valued at between five and 10 times its annual profit, depending on its history, potential and other market factors; a large, growing quoted company with good prospects can have a P/E ratio of over 20.
The IoD recommends looking at newspapers such as the Financial Times to gauge historic price/earnings ratios for companies in your sector, and adjusting them accordingly – it says that the P/E ratio for a small private company is around half of that of a listed company in the same sector. However, it is very difficult to get figures for comparison for other privately owned enterprises, as the details of the actual deal will remain confidential, with speculation in the trade press or clauses tying in the vendor often inflating the real figure.
Nevertheless, it should be possible to get a rough range for the P/E ratio. And of course, as mentioned earlier, you will have begun preparing your business for sale well in advance of making any concrete plans, taking measures to increase the apparent profitability of the business.
Calculating entry cost gives you an idea of how much it would cost to build a start a business and build it to the same size and with the same profits as the one being sold. To do this, you have to work out how much it would cost to purchase your assets all over again, develop the products, recruit and train the workforce, and build up a customer base – all from scratch.
You must also be quite brutal with your business and put yourself in the buyer’s shoes: if the business was located elsewhere, or used different raw materials, would it have a lower entry cost?
Finally, there is the most technical of all methods: discounted cashflow. Like the price/earnings ratio, it is best used for businesses that are stable, mature and generate cash, i.e., enterprises in which you have confidence that the returns and profits will at least match the historic values for the next decade or so.
To calculate this, establish the estimated profits for a given time period in the future. You then adjust this figure to take account of the diminishing value of money over time. How much would you have to leave in an account, at current bank interest rates, to produce those profits over that period of time? This will give you a ‘base figure’ for how much a person might be prepared to pay – but any company will be riskier than investing in a savings account. So replace the bank interest rate with a higher figure reflecting that greater risk (which will produce a lower initial sum).
For example, a company makes a profit of £10k per annum, which is forecast to remain steady for the next 10 years. Let us assume our potential buyer wants to achieve a 10% rate of return. But £10k received in five years time is not worth the same as £10k received today – because if I received that £10k today I could put it in a bank (where let us assume there is a 5% interest rate) and in five years time it would be worth £12,763. Working backwards, then, £10k received in five years’ time is actually worth £7,835 today, whereas £10k in 10 years’ time is actually worth £6,139 today. Adding all these figures together will give the buyer an idea of how much he should pay now to receive the returns from the business in the future.
Although there is no right approach for any one business, certain industry sectors use industry-standard ‘rules of thumb’ as shortcuts to valuation. These quick rules are also commonly used in the trade press to discuss the dynamics of the industry. For example, investment management companies are rated on the percentage of fund under management; estate agents are valued on the number of branches they have; and suitable prices for nursing homes are worked out on the basis of the number of beds. Retail and leisure businesses – such as pubs – tend to use standard multiples of turnover or profit after tax.
The ‘multiplier’ used when calculating the value in this way will vary depending on the security of the income. Sectors in which personal relationships are of paramount importance tend to use lower multipliers than asset- or technology-reliant businesses, for obvious reasons.
If you or your colleagues are an obviously key ingredient of the company’s success, buyers may well offer a higher price if you are prepared to commit to staying on as an employee or consultant for a fixed period of time. This reduces disruption and smooths the transition to new owners. However, the buyers may offer to pay a second sum at the end of that period – a risky route if they already own companies that are not entirely solvent.
Whatever the sector, though, buyers tend to regard bigger businesses as more secure – they have greater resources with which to weather any unforeseen economic storms. Buyers will pay more for such reliability.
Businesses can have other advantages that will increase the security of their profits. For example, a business might have intellectual property rights over a particular manufacturing process, recipe or marketing logo; or it might have a contract with a major multinational or with the government.
The nature of the buyer
Finally, the value of the business will also depend on the nature of the buyer. Acquirers will generally fall into two categories:
A financial buyer, such as a venture capitalist, will generally look at your business in isolation, analyse the viability of its profits, and examine whether it could increase them if it were to streamline the company.
A strategic buyer, on the other hand, will be in the same or a related sector. Combining your business with his might enable him to cut costs in a way not possible for the financial buyer. He could centralise the sales and marketing function, for example. This type of buyer is also likely to have a greater understanding of – and faith in – the sector, and, consequently, your business model.
But while strategic buyers tend to be able to offer higher sums, they are few and far between.
Approaches from competitors are also dangerous. Do you really want to give a potential buyer divulge the mechanics of your business, only for him or her to abort the sale and remain a competitor? Then, he or she would be equipped with knowledge of your weak points, which he or she could then exploit, and your strengths, which he or she could then replicate?
One of the great advantages of knowing about valuation techniques is that it allows you to see what steps you can take to increase the value of your business.
http://uk.businessesforsale.com/uk/valuing-a-business.aspx
Last updated: 7/11/2008 View printable version
Selling your business will probably be the largest financial transaction you will ever undertake. Getting the right price is crucial.
- asset-based,
- price/earnings ratio,
- entry cost and
- discounted cash flow.
Throughout the process, you will need to bear in mind what ‘components’ your business has: the assets it owns, the goodwill it has with customers and suppliers, and the expertise of its employees.
- financial and
- strategic.
http://uk.businessesforsale.com/uk/valuing-a-business.aspx
Valuing a Business: The Buyer's Perspective
Last updated: 10/25/2007 View printable version
- Start-ups are difficult to sell under the best of circumstances.
- The next time period in the life of a business is after three years, at which point there is some history, and a track record is beginning.
- The third period is usually after the company has been in business for a minimum of five years. Now the company has a track record and a reasonable history of performance.
Is the current management motivated and what incentives do they need?
Are current management values, etc., consistent with the buyers?
Does current management have the leadership skills to move the company forward?
Is the depth of current management sufficient to fulfill projected growth plans?
Is current management able to handle change?
Employee Stability
Industries with low failure rates
Industries with any type of regulation, licensing, patents - anything that might restrict the amount of competition
Industries with established products or services coupled with stable pricing
Competition
Inventory Valuation: Tricks and Traps!
by Toby Tatum
Buying or selling a small business, if done in a way that minimizes the potential for purchase negotiations to fall apart or for post-transaction animosity—or possibly even litigation—between the buyer and the seller, can be a complicated process. As a business broker and as a former business owner who has bought and sold several restaurants, I have experienced first hand dozens of tricks, traps and unpleasant surprises that lie waiting to snare unsuspecting buyers and sellers. I addressed all of these things in my book, Anatomy of a Business Purchase Offer.
There is one incident that I'll tell you about here that I encountered as a business broker assisting a client with selling his discount liquor/convenience store. It had to do with the amount the buyer would pay for the seller’s inventory.
In this case, which is typical, the purchase offer indicated the amount the buyer would pay for the inventory on hand at close of escrow. The offer stated that the buyer would purchase the inventory at the seller’s cost and included the caveat that the price stated in the purchase offer was only an estimate; that the exact value of the inventory would be determined via a physical count to be taken immediately preceding close of escrow.
As agreed between the parties, in the early morning hours on the day escrow was to close, the seller had an inventory counting service come into his store, count every product on the shelves and note the retail price of each item. The seller therewith came to the closing meeting with an exact representation of the value of his inventory at retail. And here is where the transaction process fell apart.
During the course of purchase negotiations, the seller told the buyer that, on average, his merchandise’s retail price was 30% above his wholesale cost. So, with a letter from the inventory counting service stating that the value of the seller’s inventory at retail prices was determined to be $130,000, the buyer agreed to pay 70% of that amount, or $91,000. The seller said that was not enough, an argument ensued and the buyer, together with the business broker assisting him, walked out of the meeting. The deal had fallen apart at the very last stage in the process.
Fortunately for me at least, since I wasn’t going to get paid unless the deal closed, the buyer and seller got back together later that day and consummated the transaction. The buyer agreed to pay the seller $100,000 for his inventory instead of the $91,000 he previously insisted was the correct amount.
So, whose calculation of the seller’s cost for the inventory was right, the buyer’s or the seller’s? I’ll give you a hint: I was representing the seller. Since the seller’s merchandise was marked up 30% (on average) above its wholesale cost, then the cost of goods sold reflected on his Profit & Loss statement was 76.9%. For example, if an item cost $1.00 and is sold for $1.30, the cost of goods sold expressed as a percent of the selling price is $1.00 divided by $1.30 which equals 76.9%. Therefore, once the retail value of the inventory was determined to be $130,000, the correct way to calculate its wholesale cost was to multiply that amount by the seller’s cost of goods sold of .769 as reflected on his P&L. $130,000 times .76923 = $100,000.
In the example I just cited, determining the wholesale cost of a business owner’s inventory given its retail price is simple. However, not all value determinations are this simple. In some cases it may be best to separate merchandise by the categories appearing on the profit and loss statement and calculate the wholesale cost of each category using the method described above. In other cases, the best way is to match each item of inventory with the vendor’s invoice—it all depends on the unique circumstances of a particular business, what’s reasonable and practical and what the buyer and seller can agree upon. I recommend that the buyer state the valuation methodology for the inventory in the offer itself. Doing so should avoid the kind of unfortunate incident I have related here.
A few days later the buyer asked me to meet him at the store he had just purchased. He said he wanted to show me something. When I met him at his new business he showed me several items on the shelves. Although he had no proof, he said it appeared that the seller had gone through his entire stock of merchandise the night before the escrow closing day and placed new retail price stickers on everything—at higher prices than his standard 30% mark-up!
Be careful, it’s a jungle out there!
http://www.businessbookpress.com/articles/article103.htm
Buying or selling a small business, if done in a way that minimizes the potential for purchase negotiations to fall apart or for post-transaction animosity—or possibly even litigation—between the buyer and the seller, can be a complicated process. As a business broker and as a former business owner who has bought and sold several restaurants, I have experienced first hand dozens of tricks, traps and unpleasant surprises that lie waiting to snare unsuspecting buyers and sellers. I addressed all of these things in my book, Anatomy of a Business Purchase Offer.
There is one incident that I'll tell you about here that I encountered as a business broker assisting a client with selling his discount liquor/convenience store. It had to do with the amount the buyer would pay for the seller’s inventory.
In this case, which is typical, the purchase offer indicated the amount the buyer would pay for the inventory on hand at close of escrow. The offer stated that the buyer would purchase the inventory at the seller’s cost and included the caveat that the price stated in the purchase offer was only an estimate; that the exact value of the inventory would be determined via a physical count to be taken immediately preceding close of escrow.
As agreed between the parties, in the early morning hours on the day escrow was to close, the seller had an inventory counting service come into his store, count every product on the shelves and note the retail price of each item. The seller therewith came to the closing meeting with an exact representation of the value of his inventory at retail. And here is where the transaction process fell apart.
During the course of purchase negotiations, the seller told the buyer that, on average, his merchandise’s retail price was 30% above his wholesale cost. So, with a letter from the inventory counting service stating that the value of the seller’s inventory at retail prices was determined to be $130,000, the buyer agreed to pay 70% of that amount, or $91,000. The seller said that was not enough, an argument ensued and the buyer, together with the business broker assisting him, walked out of the meeting. The deal had fallen apart at the very last stage in the process.
Fortunately for me at least, since I wasn’t going to get paid unless the deal closed, the buyer and seller got back together later that day and consummated the transaction. The buyer agreed to pay the seller $100,000 for his inventory instead of the $91,000 he previously insisted was the correct amount.
So, whose calculation of the seller’s cost for the inventory was right, the buyer’s or the seller’s? I’ll give you a hint: I was representing the seller. Since the seller’s merchandise was marked up 30% (on average) above its wholesale cost, then the cost of goods sold reflected on his Profit & Loss statement was 76.9%. For example, if an item cost $1.00 and is sold for $1.30, the cost of goods sold expressed as a percent of the selling price is $1.00 divided by $1.30 which equals 76.9%. Therefore, once the retail value of the inventory was determined to be $130,000, the correct way to calculate its wholesale cost was to multiply that amount by the seller’s cost of goods sold of .769 as reflected on his P&L. $130,000 times .76923 = $100,000.
In the example I just cited, determining the wholesale cost of a business owner’s inventory given its retail price is simple. However, not all value determinations are this simple. In some cases it may be best to separate merchandise by the categories appearing on the profit and loss statement and calculate the wholesale cost of each category using the method described above. In other cases, the best way is to match each item of inventory with the vendor’s invoice—it all depends on the unique circumstances of a particular business, what’s reasonable and practical and what the buyer and seller can agree upon. I recommend that the buyer state the valuation methodology for the inventory in the offer itself. Doing so should avoid the kind of unfortunate incident I have related here.
A few days later the buyer asked me to meet him at the store he had just purchased. He said he wanted to show me something. When I met him at his new business he showed me several items on the shelves. Although he had no proof, he said it appeared that the seller had gone through his entire stock of merchandise the night before the escrow closing day and placed new retail price stickers on everything—at higher prices than his standard 30% mark-up!
Be careful, it’s a jungle out there!
http://www.businessbookpress.com/articles/article103.htm
VALUING THE BUSINESS
Valuing the business is not as hard as you think, but you should never completely rely on a broker's or seller's estimate as to what a business is worth. Remember that buying a business is fundamentally an investment and consequently the business is worth only as much as its ability to generate profits for you based on how much money you must put into it. If you are going to work in the business as most people do, then the business should also pay you a fair wage in addition to the profits. The best way to determine a business's value is to work backwards from the available profits that a seller can prove.
For example, let's say that a business has a total of $100,000 pre-tax profits (proven by IRS tax returns for the latest full year of operation), before allowing for an owner/manager's wage. You plan to work full time in the business (and believe me, you probably will!), and a fair wage for the work if you were to hire someone to do it is $40,000. That leaves $60,000 of available profit to work with but don't forget to deduct the income taxes that you'll have to pay on this, probably about $18,000 depending on the state and city the business is in, plus other personal factors (figure at least 30%). That gets you down to about $42,000 of profits left to be able to either
There are many ways to work with this $42,000, but most lenders of money to buy a business, whether they are the sellers themselves or others, want to see a relatively short payoff term (let's say 5 years) and a fair interest rate on the money (let's say 10%). When you do the math to determine the values of $42,000 yearly payments for 5 years at 10% interest, the amount turns out to be about $165,000. This is the approximate total value of the business and a good starting point for negotiations.
When I say total, I mean total. The total value and therefore the business's selling price must include all closing costs, assets, transfer and franchise fees, etc. Remember; a business is worth only as much as its ability to produce profits for you. Of course, if you change the time period for payoff of the purchase price, the interest rate, the anticipated taxes, and other factors, the price you can afford to pay for the business can go up or down.
http://www.businessbookpress.com/articles/article109.htm
- pay off the debt you incur to buy the business or
- to provide you with a reasonable return on your cash investment (if you're lucky enough to have this much cash).
Common methods of valuing a business
There's a range of ways to value a business. Valuations based on multiples of future earnings and the capitalisation of future cashflows are the most common. There are a number of common valuation methods:
1. Businesses with a record of sustainable profits are often valued at a multiple of earnings. Profits are adjusted for any unusual, one-off items to arrive at an estimate of 'normalised' earnings. Smaller businesses are usually valued at a lower multiple than similar, larger companies.
2. Mature, cash-generating businesses can be valued in a similar way but based on cashflow. Future cashflows are estimated and discounted - this is known as discounted cashflow. Long-term cashflow is worth less than cashflow due shortly.
3. An asset valuation might be appropriate for stable businesses with significant tangible assets - property or manufacturing businesses, for example. Your starting point is the value of assets stated in the accounts - known as the 'net book value'. These figures are then refined to reflect factors such as changes in the value of assets or bad debts.
4. The cost of creating a business similar to yours can be used as a basis for valuation. Costs could include buying equipment, employing staff, developing products, attracting customers, and so on. It may be possible to estimate this 'entry cost' as a benchmark of your business' value. Of course, if the cost of entry is low there's little likelihood of you achieving a successful sale.
In some industries, there are established criteria for valuing businesses, eg by the number of branches an estate agency has.
A potential buyer may use more than one method to get a range of values for your business. In the end, however, any price will be a matter for negotiation.
Pneumonic: MADE
Multiple of Earnings
Asset Valuation
Discounted Cashflow
Entry Cost
http://www.businesslink.gov.uk/bdotg/action/detail?r.s=sc&r.l1=1073861225&r.lc=en&r.l3=1074410825&r.l2=1074400490&r.i=1074411173&type=RESOURCES&itemId=1074411241&r.t=RESOURCES
1. Businesses with a record of sustainable profits are often valued at a multiple of earnings. Profits are adjusted for any unusual, one-off items to arrive at an estimate of 'normalised' earnings. Smaller businesses are usually valued at a lower multiple than similar, larger companies.
2. Mature, cash-generating businesses can be valued in a similar way but based on cashflow. Future cashflows are estimated and discounted - this is known as discounted cashflow. Long-term cashflow is worth less than cashflow due shortly.
3. An asset valuation might be appropriate for stable businesses with significant tangible assets - property or manufacturing businesses, for example. Your starting point is the value of assets stated in the accounts - known as the 'net book value'. These figures are then refined to reflect factors such as changes in the value of assets or bad debts.
4. The cost of creating a business similar to yours can be used as a basis for valuation. Costs could include buying equipment, employing staff, developing products, attracting customers, and so on. It may be possible to estimate this 'entry cost' as a benchmark of your business' value. Of course, if the cost of entry is low there's little likelihood of you achieving a successful sale.
In some industries, there are established criteria for valuing businesses, eg by the number of branches an estate agency has.
A potential buyer may use more than one method to get a range of values for your business. In the end, however, any price will be a matter for negotiation.
Pneumonic: MADE
Multiple of Earnings
Asset Valuation
Discounted Cashflow
Entry Cost
http://www.businesslink.gov.uk/bdotg/action/detail?r.s=sc&r.l1=1073861225&r.lc=en&r.l3=1074410825&r.l2=1074400490&r.i=1074411173&type=RESOURCES&itemId=1074411241&r.t=RESOURCES
Investment Club Performance
Investment clubs serve many useful functions.
Ref: Barber, Brad, and Terrance Odean,
"Too many cooks spoil the profits: Investment Club Performance."
Financial Analysts Journal, Jan/Feb 2000, 17-25
Using data from a large discount brokerage firm, Barber and Odean looked at the performance of 166 investment clubs over the period 1991 through 1997. They found that these clubs tended to purchase high-beta, small-cap growth stocks and had an average holding period of about 18 months. They found that 60% of the clubs underperformed the market, by an average of 3.7 percentage points per year.
- They encourage savings.
- They educate their members about financial markets.
- They foster friendhsips and social ties.
Unfortunately, their investments do not beat the market.
"Too many cooks spoil the profits: Investment Club Performance."
Financial Analysts Journal, Jan/Feb 2000, 17-25
Using data from a large discount brokerage firm, Barber and Odean looked at the performance of 166 investment clubs over the period 1991 through 1997. They found that these clubs tended to purchase high-beta, small-cap growth stocks and had an average holding period of about 18 months. They found that 60% of the clubs underperformed the market, by an average of 3.7 percentage points per year.
"What do you think of the market?"
Perhaps the most common investment question is "What do you think of the market?"
Expectations about the future are extremely important in the determination of security prices. Even if you are a firm believer in the efficient market hypothesis, it is difficult to make informed investment decisions with complete disregard for:
The Greenspan Model is a heuristic many people use as one means of estimating the over- or under- valuation of the broad market. The model is simple: just subtract the S&P 500 earnings yield from the current yield on a 10-year Treasury security.
Greenspan market value = 10-year Treasury yield - S&P 500 earnings yield
When the result is positive, the market is overvalued.
When it is negative, the market is undervalued.
According to the Greenspan model, the broad stock market was overvalued for the entire decade of the 1990s. There were buying opportunity in 2003 and 2004, but in the mid-2005 stocks were starting to get pricey again.
As with historical PE ratios or earnings yield figures, the Greenspan model offers some historical indication of the reasonableness of the current level of the market, given estimated earnings and the interest rate environment.
- To an informed group of market analysts, the question invites intellectual discussion and is very difficult to answer succinctly.
- In casual conversation with friends, however, the question can be like an overused pickup line at a cocktail party.
Expectations about the future are extremely important in the determination of security prices. Even if you are a firm believer in the efficient market hypothesis, it is difficult to make informed investment decisions with complete disregard for:
- the current level of the popular indexes or
- the prospects for the economy.
The Greenspan Model is a heuristic many people use as one means of estimating the over- or under- valuation of the broad market. The model is simple: just subtract the S&P 500 earnings yield from the current yield on a 10-year Treasury security.
Greenspan market value = 10-year Treasury yield - S&P 500 earnings yield
When the result is positive, the market is overvalued.
When it is negative, the market is undervalued.
According to the Greenspan model, the broad stock market was overvalued for the entire decade of the 1990s. There were buying opportunity in 2003 and 2004, but in the mid-2005 stocks were starting to get pricey again.
As with historical PE ratios or earnings yield figures, the Greenspan model offers some historical indication of the reasonableness of the current level of the market, given estimated earnings and the interest rate environment.
Latexx keeps up the pace
(Figures in Malaysian Ringgits)
Recent Stock Performance:
1 Week -2.9%
13 Weeks 32.8%
4 Weeks 39.8%
52 Weeks 734.4%
Latexx's price has moved up steadily. The stock was the second highest gainer on Bursa Malaysia between Jan 1 and Oct 30, up 456% from 48 sen.
CIMB forecasts Latexx's net profit to sustain a surge to RM 82 million or earnings per share (EPS) of 42.1 sen next year, up 58% from a forecast net profit %M 51.9 million (EPS of 26.7 sen) this year.
The investment bank has projected a traget price of RM 3.97 before the end of next year. The stock closed at RM 2.44 last Thursday.
The Edge Malaysia November 9th, 2009
The importance of not buying shares near the top of the market peaks
Stock prices can be very volatile.
The price movements even within a year can be considerable (the average is 38 per cent).
The minimum movement within a year is still 19 per cent from the highest to the lowest price which is about 6 times greater than the average dividend yield of 3 per cent.
This means that price changes can very quickly wipe out any return provided by dividend.
This means that the value of one's investment can vary considerably from year to year. One must be able to sustain such losses if one wishes to invest in shares.
Therefore, if we buy our shares when the market is at a reasonable level (that is when the index is around the trend line or below), we can rely on the long term rising trend to obtain our gain from the market.
Unless we buy shares near the top of the peaks, we should be able to profit from buying shares after a few years. It is therefore important to go for the long run.
The price movements even within a year can be considerable (the average is 38 per cent).
The minimum movement within a year is still 19 per cent from the highest to the lowest price which is about 6 times greater than the average dividend yield of 3 per cent.
This means that price changes can very quickly wipe out any return provided by dividend.
This means that the value of one's investment can vary considerably from year to year. One must be able to sustain such losses if one wishes to invest in shares.
Therefore, if we buy our shares when the market is at a reasonable level (that is when the index is around the trend line or below), we can rely on the long term rising trend to obtain our gain from the market.
Unless we buy shares near the top of the peaks, we should be able to profit from buying shares after a few years. It is therefore important to go for the long run.
Sunday 8 November 2009
Good fundamental reasoning is important. Guts too!
Forty-four billion reasons to support the bull market
Warren Buffett has just made his biggest investment ever in buying Burlington Northern Railroad Company in the US.
By Alan Steel
Published: 1:21PM GMT 06 Nov 2009
Alan Steel The two big differences between Warren Buffett and the thousands of pessimists predicting our financial demise is that he puts his hard earned cash on the line, and he is usually right.
Warren Buffett, in buying Burlington Northern Railroad Company in the US has just made his biggest investment ever. All said and done the business came with a $44 billion price tag.
He said he’s betting on an out and out recovery in the US economy and he is focusing, as all good investors should, on the medium to long term.
Meanwhile, pessimists are pulling their money out of equity funds and piling into fixed interest bonds.
So no doubt they will not only be dismayed by Warren Buffett’s move, but also by Cisco CEO’s statement on Thursday which ignited US stockmarkets. He stands alongside his counterparts at Apple, Amazon and Intel by stating “the quarter was very strong and the recovery is gaining momentum”.
Further good news comes from the US Institute for Supply and Management who reckon the US GDP is likely now growing at an annualised rate of 4.5pc. Workers’ productivity also offers a guide.
This week the US Labour Department said output per hour of non farm workers rose at an annual rate of 9.5pc in the quarter, more than four times the average productivity growth rate of the last 25 years. Taking that together with the previous quarter’s 6.9pc, it’s the strongest productivity growth rate over any six month period since 1961.
All of this, plus the continued scepticism among experts and ordinary investors, tells us to expect a continuing worldwide stockmarket recovery.
Alan Steel is chairman of Alan Steel Asset Management
http://www.telegraph.co.uk/finance/personalfinance/investing/6514334/Forty-four-billion-reasons-to-support-the-bull-market.html
Warren Buffett has just made his biggest investment ever in buying Burlington Northern Railroad Company in the US.
By Alan Steel
Published: 1:21PM GMT 06 Nov 2009
Alan Steel The two big differences between Warren Buffett and the thousands of pessimists predicting our financial demise is that he puts his hard earned cash on the line, and he is usually right.
Warren Buffett, in buying Burlington Northern Railroad Company in the US has just made his biggest investment ever. All said and done the business came with a $44 billion price tag.
He said he’s betting on an out and out recovery in the US economy and he is focusing, as all good investors should, on the medium to long term.
Meanwhile, pessimists are pulling their money out of equity funds and piling into fixed interest bonds.
So no doubt they will not only be dismayed by Warren Buffett’s move, but also by Cisco CEO’s statement on Thursday which ignited US stockmarkets. He stands alongside his counterparts at Apple, Amazon and Intel by stating “the quarter was very strong and the recovery is gaining momentum”.
Further good news comes from the US Institute for Supply and Management who reckon the US GDP is likely now growing at an annualised rate of 4.5pc. Workers’ productivity also offers a guide.
This week the US Labour Department said output per hour of non farm workers rose at an annual rate of 9.5pc in the quarter, more than four times the average productivity growth rate of the last 25 years. Taking that together with the previous quarter’s 6.9pc, it’s the strongest productivity growth rate over any six month period since 1961.
All of this, plus the continued scepticism among experts and ordinary investors, tells us to expect a continuing worldwide stockmarket recovery.
Alan Steel is chairman of Alan Steel Asset Management
http://www.telegraph.co.uk/finance/personalfinance/investing/6514334/Forty-four-billion-reasons-to-support-the-bull-market.html
Commercial property values prompt fears of a bubble
Commercial property values prompt fears of a bubble
Concerns that the UK property market is entering a bubble have been exacerbated after new data showed yields have returned to 2006 levels after seeing their biggest monthly decline since 1993 in October.
By Graham Ruddick, City Reporter (Automotive, Healthcare, Property)
Published: 7:56PM GMT 06 Nov 2009
Yields, which measure rental returns against the value of a property and are a useful barometer of risk appetite, fell below 5pc for prime retail properties in October, below 6pc for offices, and 7pc for industrial property, according to BNP Paribas Real Estate. An overall fall of 35 basis points was the biggest since 1993, Cushman & Wakefield said.
There are fears that property values are recovering too quickly because of a lack of supply and strong overseas demand.
Segro, the warehouse owner, on Friday sold its Great Western Industrial Park in Southall, West London for £110.4m to the Universities Superannuation Scheme at a yield of 6.9pc.
Concerns that the UK property market is entering a bubble have been exacerbated after new data showed yields have returned to 2006 levels after seeing their biggest monthly decline since 1993 in October.
By Graham Ruddick, City Reporter (Automotive, Healthcare, Property)
Published: 7:56PM GMT 06 Nov 2009
Yields, which measure rental returns against the value of a property and are a useful barometer of risk appetite, fell below 5pc for prime retail properties in October, below 6pc for offices, and 7pc for industrial property, according to BNP Paribas Real Estate. An overall fall of 35 basis points was the biggest since 1993, Cushman & Wakefield said.
There are fears that property values are recovering too quickly because of a lack of supply and strong overseas demand.
Segro, the warehouse owner, on Friday sold its Great Western Industrial Park in Southall, West London for £110.4m to the Universities Superannuation Scheme at a yield of 6.9pc.
Price is not the issue here
Lachlan Murdoch outmuscles Russell Crowe: Master and Commander star fails to land £12m Sydney house
Lachlan Murdoch, the eldest son of Rupert Murdoch, chairman and chief executive of News Corporation, has paid a record A$23m (£12.7m) for a home in Sydney, Australia, after seeing off a host of stars in an auction.
By Graham Ruddick, City Reporter
Published: 8:50PM GMT 06 Nov 2009
The property is the French government?s former consulate in Sydney?s exclusive eastern suburbs Mr Murdoch beat nine other bidders to secure the property, named 'Le Manoir’, including actor Russell Crowe and actress Nicole Kidman.
The property is the French government’s former consulate in Sydney’s exclusive eastern suburbs. It is a six-bedroom residence with panoramic views of the Pacific Ocean as well as a tennis court, swimming pool, five bathrooms, two studies, a guest powder room and a three-car garage.
The French government paid just A£26,000 for the property in 1956.
Bidding for the property, which lasted 10 minutes, opened at A$18m and bidders were asked to pay a refundable deposit of A$50,000 before the auction began.
The acquisition is thought to be the most expensive home purchase in Australia this year. Mr Murdoch and his wife, a television presenter and former model, are expecting their third child. He leads investment group Illyria Pty.
When should a stock be sold?
In a portfolio of good quality stocks bought at fair or bargain price, there are usually few reasons for selling. However, the businesses of these companies need to be tracked regularly and their quarterly results announcements followed.
When should a stock be sold?
Firstly, if the fundamentals of the stock are deteriorating, the stock should be sold urgently.
Another good reason would be when the stock is overpriced.
Another good reason would be when the stock is overpriced.
- Be alert when the PE of the stock has risen by more than 50% above its usual average PE.
- Reappraise the fundamentals and valuations of this stock, in particular, its future earnings growth potential.
- the present high PE cannot be justified or
- if the present high PE has run ahead of the fundamentals of the stock.
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