46. How do you value a business?

“If you are thinking of buying or selling a business … here is a combined personal and professional perspective!”

So – how do you value a business?

Any accountant who has sat professional exams will remember this as a study topic loved by examiners probably due to the rich source of complex calculations on some very basic data, the ease with which you can sneak in red herrings and the final 4 mark part (d) asking for the pros and cons of each method.

I pretty well mastered the mechanics of measuring return on capital employed (R.O.C.E), payback and discounted cash flow (DCF) in my academic studies. I also knew that the value of a quoted company could be calculated by multiplying its share price by the number of allocated shares.  I was, and still, am vaguely aware that an unquoted business can be valued by finding a similar quoted business and applying some sort of “sigma” value to assign risk, and then … oh never mind.  Above all I know that, like your house, a business is really only worth what a willing buyer is prepared to pay for it.

My blooding

My first experience of actually valuing a business came when the business I was working for, a small oil distributor with a £20m turnover, was being offered for sale by the parent company to Texaco.

Texaco sent a whole team of young grey suited investment analysts to my office and I was charged with providing them with anything and everything that they required.  They didn’t say much – but each was armed with a laptop (and in those days hardly anyone had a laptop!) and they spent hour after hour slapping figures into Lotus123 spreadsheets.

I can remember asking one of them how they eventually came to a decision.  He candidly told me that basically the vice-president had already decided whether or not he wanted to buy the business and their job was to manipulate the data to support that decision.

Since then I have had quite a lot of experience of justifying buying and selling proposals to boards and I am convinced that the Texaco experience can be applied to 90% of business sales.

And it’s not surprising.  If a business is considering buying another business then someone senior enough to make the decision is considering buying and, conversely, someone is considering selling; when most people consider doing something it usually means that they want to do it.  It therefore follows that my role was to present a case to the board for buying a business that my MD wanted to buy.

And so to the more technical bits

DCF with streams of net cash inflow over the life of the acquired business discounted at the business’ cost of capital is generally considered the best way of measuring the value of an investment – whether it be an internal project or a business purchase.  It is predicated on the fact that most rational people will choose to invest in something that provides them with a positive net present value (NPV) for that investment.  Given a choice of more than one investment opportunity – and with limited resources – they will opt for the one that gives the highest NPV.  (NPV being the current value of a stream of future cash flows).

We all know that one of the “cons” of DCF is that is it difficult for a non-accountant to understand.  I don’t think it should be, but my experience with my own boards is that it is a step too far.  Often my fellow board members were (and admitted as such) very weak on the understanding of finance – and this was where I was able to add real value.

When reviewing an acquisition target I would look at 3 things in this order – cost savings, revenue streams and detailed modeling:

Costs

My priority was to accurately establish the costs savings that would accrue to our business. I was careful, as we all should be, to use figures that were relevant to us as the buyer – which meant taking out costs of the seller that we felt we could lose.  Any substantial buyer will be looking for economies of scale and will usually already have a finance department and thus have no need of another one.  And the same logic can also be applied to most admin, HR, and IT costs.

By all means look for fixed cost savings.  But bear in mind any additions to the cost of purchase such as redundancy costs under TUPE – a careful look at employment contracts is vital; ditto for costs of early termination on leases on machinery, cars and land and buildings.

Revenue

In addition to looking at costs it is important to challenge revenue streams.  Past performance can be an indicator of future performance … but not necessarily. There were plenty of video shops that had healthy historic revenues and growth; the best value that you can get from an FD is in the due diligence on the figures that s/he presents to the board.  Look for such things as new, disruptive models, obsolesce and market saturation in assessing revenue streams.

When you are thinking of purchasing a business you have to consider the role of the chief executive and senior management team – especially if they are exiting the business.  Often the success of a small business is founded on the vision, energy and commitment of the owner/ boss and if he is the seller you have to consider specifically how the revenues will stand up.  A clause in the contract retaining his or her services can be useful – though they are unlikely to have that same level of energy and commitment as prior to sale.

Modelling

Once we have established the revenue streams I would plug them into models for investment appraisal.  I don’t believe that a business can realistically look beyond five years so I’d extend these streams only as far as this.  If I couldn’t establish a positive NPV over five years I’d advise the MD against the investment.  If it was positive I would then look at R.O.C.E.  Any project with a positive NPV over 5 years will have a R.O.C.E well above the bank lending rate and boards will be impressed with this figure – which, frustratingly, many people regard as irrelevant or meaningless.

I’d also run a payback model. This was always the clincher with my boards; if they could see a payback within three years they were comfortable, four year’s slightly edgy and five years – well I never got to five years!

And as we are talking about buying and selling, one would expect that if two parties are considering a deal then they will both be looking at the same way of measuring value … won’t they?  This is typically not the case!  The seller is looking to maximise the figure paid to him – or may require a certain sum for investment elsewhere (possibly in his retirement); and this figure is often tempered by softer considerations; for example, safeguarding the jobs of a longstanding loyal workforce.

And so we are now in to the realms of negotiation.  Over to you, Mr. MD!

Chris Hughes is a Client FD with Tectona.

To find out more about valuing a business or if you would like to discuss any of the other topics with Tectona, please contact Mark Nicholls on 07818 407061.

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