Methods of Business Valuation M&A Basics Series - Article 2
Ultimately a business is worth whatever a person is willing to pay for it and, as in most things in life, beauty is in the eye of the beholder. Nonetheless, when engaging in an M&A process, it is crucial for buyers, sellers and investors to know the valuation methods that others may use, and the valuation results they may produce. This article provides a very high-level guide to some common approaches to business valuation.
1. EBITDA Multiples: The most common valuation method is to apply an EBITDA multiple to the business. EBITDA (earnings before interest, taxes, depreciation and amortization) is a measure of a company’s ability to generate operating earnings and the multiple represents the number of years it will take the buyer to recover its investment from those operating earnings. The multiples applied to EBITDA vary by industry but are typically in the range of 3 to 6 times for a small to medium‑sized business depending on a variety of factors.
2. Discounted Cash Flow: This is often the preferred valuation method for investors. Essentially, it uses the concept of time value of money to determine the value of the business today, based on what it will earn in the future.
Imagine an investor is considering an investment in a widget factory, but plans to cash out his or her investment in five years. For the investor, the widget factory is worth today what it can earn during those five years, plus his or her share of the value of the business at the end of the five years. However, future cash flow numbers and the future value of the business are unknown. The discounted cash flow method applies adjustments or "discounts" to account for those unknowns as well as the time that the investor must wait for his or her return. Using this method, the value is the total of the cash flows, adjusted or discounted, plus the value remaining (or residual value), also discounted.
3. Going-Concern Value (or Capitalization of Net Earnings): Like the discounted cash flow method, the going-concern value method (or calculation of net earnings method) calculates the business' value today based on its capacity to produce a stream of cash flow (or net earnings) in the future. This method uses the revenues (or net earnings) of previous years to project future revenues (or net earnings), and it assumes those revenues (or net earnings) will not change. The greater the cash flow (or net earnings) the business generates today, and will continue to generate in the future, the higher the business' value will be today. Again, the value today will be determined by the buyer/investor based on his or her projected rate of return over their investment period.
In commercial real estate transactions, the capitalization rate (normally referred to as the “cap rate”), is often used to value real estate. It is the ratio of net operating Income (NOI) to property asset value. For example, if a property was listed for $1,000,000 and generated an NOI of $100,000, then the cap rate would be $100,000/$1,000,000, or 10%.
4. Liquidation Value: This method is typically used only if a business is in serious financial trouble and the assets of the business are being sold to satisfy its creditors. Liquidation value is the value of all assets minus the value of all debts. However, all assets are assigned distressed values, and all debts are totaled at book value.
Most assets sold under duress are usually sold at values discounted from their fair market value. Tangible assets, such as land, may have a liquidation value close to their market value but inventories and accounts receivable are usually valued at significantly less than what is shown in the books.
Keep mind that these valuation methodologies are just a starting point. Value may also be impacted by other factors including inherent strategic value, anticipated cost-savings or synergies, or even emotion or ego. In particular, value may also be impacted by market conditions (such as attractiveness of the industry and the number of potential buyers with access to adequate capital), the value of tangible assets, the value of intangible assets including goodwill and intellectual property, the attractiveness of the business location, the quality of the customers, whether any significant barriers to entry exist, the degree and strength of existing or potential competition, the value of any expected synergies/cost savings, and so on.
Invitation for Discussion:
Business valuation is a complex task, and a financial advisor with experience in business valuation can be an invaluable asset. As lawyers, we are not experts in business valuation. However, we do have a wealth of experience as legal advisors on M&A transactions, both large and small. And we appreciate the importance of all parties to the transaction, including clients and their lawyers, understanding how the business is being valued.
If you are contemplating buying or selling a business, please do not hesitate to contact one of the lawyers in the business law group at Shea Nerland LLP. We would be happy to assist you on this exciting journey.
Note that the foregoing is for general discussion purposes only and should not be construed as legal advice to any one person or company. If the issues discussed herein affect you or your company, you are encouraged to seek proper legal advice.