by Robin McGregor, Director, Christie Griffith, Forensic Accountants
My two favourite sayings about business valuation are first, that it is a black-art and second, that thevalue of a business is what someone will pay for it. Unfortunately, neither of these statements are true. The first statement is often accompanied by a casual shrug of the shoulders to discourage further examination of why the valuation that had been placed on a business is very different from what is offered to the seller. The second statement is simply a fundamental error in understanding the valuation process.
A valuation is an objective estimate of the worth of a business at a point in time and is based on the factors that the valuer has chosen to be representative of likely purchasers. However, the price paid by a purchaser may be more or less than the value placed on the business for a great many reasons, some that should have been considered by the Valuer and others that are known only to the purchaser. A business valuation does include elements of subjective judgement, but these should be clearly stated and supported by evidence. If valuers adopt these principles then it is easy for those comparing valuations to see and understand the impact of changes in the valuation assumptions and for valuers to agree between themselves the areas of disagreement in a constructive fashion.
What is Value?
There are different measures of value and different approaches to the measurement of those values, which is why the first question that a valuer often asks is, what is the purpose of the valuation. The answer to that question is likely to influence the choice of valuation methodology that is appropriate. For an active trading business, a commonly used metric is ‘fair market value’ and this can be defined as: the highest price, expressed in terms of cash or cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, acting at arm’s length in an open and unrestricted market, when neither is under any compulsion to buy or sell and when both have reasonable knowledge of the relevant facts. Fair market value implies a calculation that should be carried out in light of the prevailing market conditions at the specific date of the valuation, whereas, ‘Fair Value’, is generally interpreted to cover a broader period of time around the date of the valuation, so that temporary dips or increases in value are discounted.
Value is determined at a specific point in time. As such, it is a function only of facts known and forecasts available at that point in time. This reflects the reality
that businesses are fluid and the future is uncertain. The commercial world is in a constant state of flux. A management team can influence or control few of these factors and the wider economic conditions arelikely to affect customers and suppliers in different, unpredictable ways. Any of these changes will have an impact on the business and hence on its value.
The value that a potential purchaser ascribes to a business is prospective and reflects the return that they expect to make on their investment. These returns are measured in cash terms so, should be adjusted for any taxes that may be due. Therefore, a purchaser is interested in the future after-tax profitability of a business rather than in its past performance. However, for valuation purposes and business planning generally, past performance is generally regarded as a reasonable basis upon which to base forecasts of future profitability. In assessing the value of a business, a valuer will discount the expected future profitability based on their evaluation of the risks that are likely to either improve or hinder the forecast level of profitability.
Value and Price
In the terminology of valuation, ‘price’ is factual and can only be established by offering an asset for sale and concluding a bargain. In contrast, value represents
the worth of an asset, given the economic and business conditions prevailing at the time. These principles apply to all valuations, whether for prospective actual valuations or to a notional valuation being prepared in relation to some date in the past. The variation between value and price arises because, in theory and in practice, each potential purchaser will have different intentions for a business and its assets; a different financing structure; a different tax position and perhaps even a different tax rate. Therefore, the post-acquisition after-tax cash flow is likely to vary been potential purchasers and consequently, the value that each purchaser places on a business will be influenced accordingly.
Additionally, the market for a business is not a perfect one. So, the price that a purchaser is willing to pay is likely to be affected by a range of subjective factors.
The starting point will, of course, be the value that the potential purchasers have calculated, but will also reflect the length of time that the business is marketed, the aims and intentions each purchaser has for the business post-acquisition, the level of interest in the business and of course, the respective negotiating skills of the parties. A price can also be heavily influenced by the degree of compulsion on either the buyer or the seller.
There are many different approaches to valuation, but broadly these recognise that any asset has either a capital value or a potential to generate recurring income. The recognition of the capital value is reflected in ‘net assets’ approaches and the income is used in ‘earnings’ approaches. A net assets approach focuses on the balance sheet of the business and adjusts the ‘book values’ of the assets and liabilities to a current fair market value. This approach would be relevant to businesses that have a high level of assets but have low turnover or profitability. One example might be a property-holding company. This approach is not suitable for businesses that have few physical assets such as a service business, for instance an estate agency. The restated fair market value of the assets less the liabilities gives the value of the business.
An earnings valuation is based on the profitability of a business. Using historical profit trends and future projections if available, a valuer will make an assessment of the likely future performance of the business. That figure is known as Future Maintainable Earnings and the valuer will then capitalise that future income stream to reach a conclusion on the value of the business. The most common ways of capitalising the value of the business is either to use an earnings multiple (obtained by comparing the value ascribed to other similar businesses) or to calculate the level of return that a potential purchaser is likely to target to compensate them for the risk associated with the business. This approach is based on the assumption that a rational investor will balance greater risk by seeking an appropriately higher rate of return. Hence a risk- averse investor might be happy to receive only a few percent interest on a cash deposit, certain in the knowledge that the capital value is not going to be eroded. So, an investor buying a business where there is a greater risk of losing some or all of the capital invested should be seeking much higher rates of return.
For comparative purposes, the risk-free rate of return is the generally taken to be equivalent to the return on a 10-year government bond, presently around 1.2%. An average risk premium above the risk-free rate that an investor might expect from investing in the UK Stock Market might be in the range 5% to 7%,
with certain industries and specific companies being perceived as lower or higher risk outwith this band. The valuer will then consider other specific risks to the business being valued. Therefore, it is possible to build-up a picture of the level of risk that a particular company should be carrying based on broad market,
industry and general economic conditions. Hence, a rational investor should seek to compensate that level of risk by requiring an appropriate level of return,
otherwise they should choose to invest in a differentless risky asset. These approaches are illustrated in the example below.
In each of the illustrations below assume that the Company has been estimated to have post-tax Future Maintainable Earnings of £100,000.Purchaser A expects the Company to perform well and considers the published price-earnings (P/E) ratios of similar companies. The published P/E ratios are based on profits after tax and an analysis of these reveals that an average multiple of 7 times is reasonable. Therefore, the value that Purchaser A attaches to the Company is simply £100,000 x 7 = £700,000.Purchaser B also expects the company to perform well and thinks that the risk associated with investing in the Company is only slightly higher than that of a Stock Market investment. So Purchaser B has calculated that the required rate of return is 10% (risk free rate of 1.2% + equity risk premium of 7% + specific company risk of 1.8%). Therefore, Purchaser B’s valuation of the business is £100,000 divided by 10% = £1,000,000.
Purchaser C considers that the Company is poorly positioned in relation to its competitors. Therefore, Purchaser C considers that an investment in the Company is at least twice as risky as investing in the Stock Market and then there is an additional competitive risk. Consequently, Purchaser C has calculated the rate of return required to be 20% (risk free rate of 1.2% + equity risk premium of 7% + specific company risk of 11.8%). Therefore, Purchaser B’s valuation of the business is £100,000 divided by 20% = £500,000.
In conclusion, in my view it is time to recognise that business valuation is not a black-art and should be conducted using an evidence based approach. Consequently, a business valuation should be set-out in an open and transparent way that demonstrates that it is well-reasoned. If these basic principles are
adopted, then the valuation report will withstand challenge in Court as it will be both theoretically sound and practically robust.
Robin McGregor is a principal in Christie Griffith, an independent niche practice specialising in forensic accounting, corporate finance and business valuation matters. Christie Griffith is led by Gordon Christie and Robin McGregor each of whom have specialist forensic expertise and are accredited as expert witnesses by both the Law Society and the Law Society of Scotland. They both have experience in the Court of Session and Sheriff Courts. Christie Griffith provides litigation support and forensic accounting services that are designed to present complex financial transactions and information in a clear andfocused way. Christie Griffith cover all types of disputes and represent clients from all sectors.