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There may be several scientific methods used to estimate the value of a small or medium-sized business. However, we could not consider one method to be the most appropriate for all cases as each business has its own structure, environment, strategy etc.
In this article, our aim is to present briefly and in a simple way four of the most well known valuation methods.
VALUATION METHODS
Net Asset Value (NAV)
Seller's Discretionary Earnings (SDE)
Price-to-earnings (P/E) ratio or (PTE)
Discounted cash-flow (DCF)
1 - Net Asset Value (NAV) | The valuation of a business’ assets is a good start to understand a business’ accounting foundations. The calculation is achieved by adding all assets, including stock, deducting any outstanding debts or liabilities and whatever is left is the book value of the business.
However, it becomes apparent that a business is more than simply its book value, since it cannot define the business potentials and momentum but rather only its financial structure.
It is important to note that a business can also have intangible assets, such as Copyright.
2 - Seller’s Discretionary Earnings (SDE) | As per many specialists, this is one of the basic and most simple methods, as it calculates the earnings before tax, depreciations & amortizations, owner’s salary, interest expense and one-time expenses (not expected to continue in the future).
Small businesses submit their tax return forms aiming to pay as little tax as possible, and thus burden the business with unnecessary expenses (such as a more expensive company car). Therefore, an estimation of the real value of the business based on the tax return form would lead to inaccurate results. On the other hand, an estimation based on the SDE method would take such factors into consideration, prevent relevant issues and thus the result would be closer to the real value.
After the SDE has been estimated, it is multiplied with the SDE multiple, or “multiplier” for each market (e.g. Food market, Transportation market etc.). Usually, multipliers range between 2 and 7.
In simple terms, the “SDE multiplier” is the viable - acceptable payback time period (usually in years) of an investment.
3 - Price-to-earnings (P/E) ratio | This is one of the most widely used methods to estimate the value of a business’ negotiated share.
There are many variations of the algorithm based on earned or projected income as well as the type of income. Since this article is about business valuation, we shall focus on this direction and assume we already know the P/E ratio in order to estimate directly the value of the business based on projected income.
P/E ratio formula is:
P/E = Share Price / Earnings per Share
4 - Discounted cash-flow (DCF)| This method calculates a business’ cash flows for a given time frame which usually ranges between 2 and 7 years.
It is discounted because over time money always costs either due to interest rates or to inflation. Therefore, one does not evaluate a business simply through cash flows but rather takes the cost of money the investor has to pay into consideration.
The DCF formula is:
CF - Cash Flows
r - Discounted Rate (e.g. inflation)
EXAMPLE
Let us see an example with simplified amounts and coefficients so we can apply it for all methods and understand the theory.
We assume that company ABC is up for sale for £950,000 in a market with stable inflation of 2.4% and the sector multiplier is 6.
The financial structure of the company are as follows:
A) 40,000 shares of £25 each
B) £50,000 cash in bank account
C) P/E: £5
D) Total Sales: £750,000
E) Expected net cash flow per year: £200,000
F) Assets (cars, equipment, stock etc.): £250,000
G) Outstanding liabilities (to banks, suppliers etc.): £300,000
H) Annual depreciations / amortisations (Straight-line method): £50,000
I) Annual director’s (Owner) salary: £50,000
J) Interest expenses: £6,000
K) Unexpected (on-off) expenses: £444,000
Is this business worth buying?
1 - Using the Net Asset Value (NAV) method the business’ value is estimated as follows: £ 50,000 (Β) + £ 250,000 (F) = £ 300,000 - £ 300,000 (G) = £ 0
2 - Using the Seller’s Discretionary Earnings (SDE) method the business’ value is estimated as follows: £ 750,000 (D) - £ 50,000 (H) - £ 50,000 (Ι) - £ 6,000 (J) - £ 444,000 (K) = £ 200,000 * 6 (sector multiplier) = £ 1,200,000
3 - Using the Price-to-earnings (P/E) method the business’ value is estimated as follows: 5 (C) * £ 200,000 (Ε) = £ 1,000,000
4 - Using the Discounted cash-flow (DCF) method the business’ value is estimated as follows: £ 195,312.5 (1st year) + £ 190,734.86 (2nd year) + £ 186,264.51 (3rd year) + £ 181,898.94 (4th year) + £ 177,635.68 (5th year) + £ 173,472.34 (6th year) = £ 1,105,318.84
We see that in terms of Net Book Value, the company is not really worth it, but in terms of its potential, we can see that the investment can actually be bought with a surplus of at least 5.27% (£50,000).
The above analysis may only be technical but the answer to whether such an investment is worth buying or not should be given after examining the following factors as well:
- Business environment
- Business industry
- Business size
- Level of automation of the business
- Technology infrastructure
- Location of the business
- Market sector prospects
- Taxation System
- Economic indicators of the country
Attention! The above methods are very general and do not take into consideration the mathematical variations or the accounting approach and modulation to these variations, which is always necessary when studying special cases. In addition, each method has its advantages as well as disadvantages. Therefore, if you wish to have an accurate estimation, it is highly recommended that you consult a professional.
If you are planning to have a business valuation, you should know how to find the most suitable professional. It is wise to take into consideration each professional’s academic and qualifications expertise area.
In our case, there are three main areas of expertise. To understand them better, please find below a brief presentation:
Economics (economists): This is quite a general term and can include both following areas as a branch of the expertise. Economists however, do focus on specific issues. They study and monitor production and consumption, demand and supply, inflation, economic recession etc.
They are most suitable to study large economies, such as a country’s economy, and their strongest skill is their ability to understand and assess opportunities within an economy.
Finance: Professionals of this field mainly study prices for products or services, interest rates, cash flows, financial markets etc.
They are considered most suitable to study, assess and set investment strategies within a business. Their strongest skill is their ability to better understand and evaluate investment potentials and momentum.
Accounting: Professionals with this expertise record any financial move and then build up a summary, analyse it and present it to directors, investors as well as other parties (such as supervisory or audit authorities).
Including tax consultants in this category, they are responsible and suitable for optimal bookkeeping and management of the financial resources of a business aiming to have a better tax treatment as well as investment attractiveness.
Their strongest skill is better understanding and evaluating the financial structure of a business.
In any case, even though all professionals with degrees in economics know the basic principles of each direction, an estimation from professionals from all three areas of expertise is considered more suitable but also the most expensive one.
Translated / Edited: Apostolia Nestoratou
© 2019 UPECO LTD
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ATTENTION!
This article intends to give only a general informative picture and should not, in any case, be taken as a rule. It is strongly recommended to seek a full and professional guidance specifically for your circumstances before making any decisions.
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