While public companies use the ASX, there is no common platform that provides the values of private companies. Small-to-medium size businesses generally have to be valued on a case-by-case basis. This can be done a number of ways.
The three most common methods used for the valuation of small-to-medium size businesses are valuations based on earnings, cash flow or assets.
Valuation based on earnings values businesses operating on a going-concern basis. This is usually applied to mature businesses. The basic level of earnings is first established using past performance as an indicator and this figure is then multiplied by an earnings multiple. The earnings multiple is derived from a range of factors that may affect a business's performance. A higher multiple means that the business has good future prospects and a low likelihood of failure; this could reflect opportunities for growth or retention of a good management team. Conversely, a lower multiple means that the business will likely require more capital investment or need measures to be taken in order to ensure its viability beyond the near-future.
For example, a middle-market furniture manufacturer, Morris Marbletops Pty Ltd, makes $50 million per annum in EBIT (Earnings before Interest and Tax). As per the market the average earnings multiple for furniture manufacturers is three. Morris Marbletops has recently signed an agreement to become the exclusive distributor for a particular Italian marble in Australia. Due to a recent surge in demand for this particular marble, analysts have assigned a higher-than-average multiple of five to Morris Marbletops.
Therefore the value of Morris Marbletops = EBIT x Earnings Multiple
= $50m x 5
= $250 million
Another approach uses a business's cash flow to estimate its worth. Known as the discounted cash flow (DCF) method, this approach values a business based on what the sum of its future cash flows are worth today. In other words, it denotes what someone is willing to pay today to receive a set of cash flows in the future. The present value of these future cash flows is calculated using a 'discount rate'. This rate represents two things: firstly, it compensates buyers for having to wait to receive cash-. This occurs because if the buyer had not bought the business, they would have been able to invest that money and potentially gain a return elsewhere. Secondly, the discount rate encompasses a 'risk premium', that reflects the return demanded by the buyer to compensate for the risk if the cash flow does not eventuate.
For example, mid-market grocer, McKay's Fruit & Veg Pty Ltd, makes an average annual cash flow of $20 million and has an estimated lifecycle of five years. Let us assume that the current interest rate is 6 percent, meaning that those who invest their money at the bank today will earn 6 percent per annum interest on that money in a year. Additionally, it has been revealed that McKay's is in danger of losing several key fruit supply contracts, which would reduce its yearly cash flow. To compensate for this risk of reduced cash flow and the foregone income of 6 percent interest per annum, analysts have assigned a discount rate of 8 percent.
The discounted cash flow formula is as follows:
Present Value = Future Cash Flow (1 - discount rate) ^ number of years before cash flow
Therefore:
Present Value = $20m (1-0.08) ^ 5
= $13,181,630
This means that the present value of $20 million received in five years time is $13, 181, 630. To calculate the worth of the business if it were producing a cash flow of $20 million per annum for each of the five years, the present value of each of those cash flows would be calculated and added together to reach the total present value of the company.
Net Present Value:
= $20m (1-0.08)^5 + $20m (1-0.08)^4 + $20m (1-0.08)^3 + $20m (1-0.08)^2 +$20m (1-0.08)
= $13,181,630 + $14,327,859 + $15,573,760 + $16,928,000 + $18,400,000
= $78, 411, 250
The total value of McKay's Fruit & Veg today, based on yearly cash flow of $20 million per annum for the next five years and a discount rate of 8 percent is $78, 411, 250.
A third approach often employed by companies with large asset bases is the asset-value approach. This method basically summarises the value of the business as the value of all of its assets and investments minus liabilities. The asset values are either taken from the company's balance sheet or a fair market value can be obtained through an asset valuation professional. This approach includes fixed assets such as property plant and equipment, inventory including raw materials and stock, as well as intangible assets, encompassing goodwill, logos, trademarks and patents.
For example a distribution business, Tandon's Trucks Pty Ltd, runs a fleet of 50 vehicles and maintains a truck depot and garage. Its assets are valued as follows:
25 Mini-trucks: $10,000 each Truck depot: $150,000
15 Half-tonne: $20,000 each Garage: $90,000
10 Large Trucks: $35,000 each
Additionally, Tandon's Trucks has an outstanding mortgage amount of $80,000. Under the asset-base approach the company will be valued as follows:
Value = (25 x $10,000) + (15 x $20,000) + (10 x $35,000) + $150,000 + $90,000 - $80,000
= $250,000 + $300,000 + $350,000 + $150,000 + $90,000 - $80,000
= $1,220,000
Therefore the total value of Tandon's Trucks as per the asset-base approach is $1,220,000.
All three of the above methods are widely accepted as accurate ways to value a business. Alternatively business owners who are looking to sell in the near future may prefer a valuation based on similar businesses that have been recently sold, to better ascertain what the market is willing to pay. This method is known as industry valuation.
If each of the above methods yields a different result, a comparison of these results can also provide useful insights into the state of your business.
In the tumultuous small business economy of today, understanding the true value of your business ensures that you are getting the most out of your assets and will help avoid the pitfalls of underperformance. So take the time out to value your business and find out what it's really worth!
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