How to value a business

Ivor Middleton

Talk for Heart Of Business Friday 18th March 2016

Budget & Financial PlanningRisk Assessment Corporate Planning Working CapitalMargin Improvement

Valuation – one part of a much larger process

Valuation is complex enough on its own.

Be aware that there is a lot more than just the value to consider when buying and selling a business.

There is a lot of jargon. I’ve tried to avoid it, but it is inevitable and will help understanding when you are involved.

Group Exercise - 5 minutes

What factors would you take into account when buying a business?

Group Exercise - Some AnswersWhat factors would you take into account when buying a business?

There are a huge number of possible factors, many hidden or unclear. Experience and the ability to smell out trouble is vital. You need a good nose, or to employ someone with one.

Reason for buying? Reason for selling?

What is being bought? Shares? Assets? Customer base?

Is there a USP? Niche? Intellectual property? (What makes them successful?)Related to the above: does it have a protected position and if so, how long for?

Profitability? Growth? Synergies?

Current good growth and profits are obviously going to make the price higher. However, there may be fewer buyers. Buyers tend to want a bargain. If the last filed accounts showed a bad year they might sniff one. Synergies or untapped potential might make the difference and haul the price up again, or increase the number of buyers for a business priced at a premium .

Group Exercise - Some Answers 2What factors would you take into account when buying a business?

Minority shareholders refusing to sell. Need ‘drag along, tag along’ agreement.

Timing – made a profit in year just past, or a loss? Sales growing? Economy? Zeitgeist?

Buying shares? Where are the bodies buried??? Asbestos. TUPE. Legal disputes. Contract clauses about to be triggered. Key client about to be lost. Key supplier just bought by a competitor. This is why due diligence is important.

Am I in competition with other buyers? (always better to be the only buyer)

Is it a closed auction? If so, what is the best bidding strategy?

Group Exercise - Some Answers 3What factors would you take into account when buying a business?

Market trends Competition

Client base – broad or dependent on a few key buyers?

Contracts with clients, suppliers, staff – do they exist, are they any good/risky, who do they favour?Supply chain and risks in the chain

Strong growth. No Growth. Declining sales.

Fire sale or insolvency

Retirement

Management team – experience; length of service; key positions filled (any gaps?); family members

Valuation methods

1) Price/ earnings ratio2) Sales or earnings multiple3) Return on investment (ROI)4) Discounted cashflow5) Net asset value (NAV)Note the move from all those words we’ve just been discussing to the attempt to find a number.

Yes, it looks like gobbledegook. All will become clear. This is the kind of language you will encounter.

1 -3 are all similar, in that they are about identifying a standard ratio/multiplier/return for a specific type of business

1) Price/ earnings ratio

Share price today------------------------------------------------------------

Earnings (last year’s profit after tax, per share)

• Commonly used ‘rule of thumb’• Need P/E ratios for comparable companies, not

broad sector P/E ratio• Easy to find in FT / Google finance screener• Quoted groups only. Discount if private co’s

1) P/E ratio exampleComparable P/E’s come from similar quoted companies , or from similar known transactions (but these are usually confidential, hence brokers are useful). Note takeover prices of quoted companies are often distorted.

Example:The appropriate similar P/E is identified as 13xThe business earned £1.3m on which it paid tax of £300k last yearThe buyer is unimpressed by various aspects of the company and considers the unquoted discount to be 45%

Hence the buyer has in mind a price of 13x (1.3 - 0.3) x 55% = £13m x 55% = £7.15 million(but will harp on about this, that and the other to get it down another £2 million if possible)The buyer’s opening offer, if forced to come clean first, is £3m.

2) Sales or earnings multiple

• Earnings before interest, tax, depreciation and amortisation (EBITDA)

• EBITDA a proxy for cash earnings• Multiply by sector or comparable company

multiple• Discount for unquoted company risks

*** Typically the preferred method ***

2) Sales / earnings multiple notesValue is heavily discounted for unquoted status – shares are not liquid (easily traded), not a diversified group. Expect 30% to 40%, even over 50% on sector or comparable quoted company. A premium may be paid for control, for a great brand, for rarity, or for a key strategic addition. Sometimes egos overpay while empire building.

Eg. A sector may have multiples of 1.3x forecast turnover and/or 7.0x forecast EBITDA, so a business with £5m turnover and £1m EBITDA would be valued at: £6.5m on a turnover basis; or £7.0m on an EBITDA basis, but that would then be discounted down to £4.5m or less as the expected sale price.

As an example of the difficulties, when calculating the sector average multiples, the market capitalisation of firms is increased for debt and reduced for cash, to get comparable values. Anomalies might need to be excluded.

A sector average may not be a useful comparable. Better to find similar firms within the sector and calculate the average multiple for those.

3) Return on investment (ROI)

Acquisitive companies often seek a specific return on the second full year after trading e.g. 20%

Adjusted profit before tax in Year 2----------------------------------------------- >= 20% Total investment(Price plus Year1, 2 investment less Year 1,2 cash)

20% sets the max price they will pay. A canny seller might be able to pin down a reasonable estimate of what this number might be.

4) Discounted cashflow (DCF)

• Purchase cost Year 0• plus Cash generated by operations• plus Income from surplus assets sold• less Capital investment• less Deferred consideration / earn out

All discounted for risk and time using a weighted average cost of capital (WACC), givesNPV – Net Present Value. Good if positive.

4) DCF notesThe discounted cashflow captures the idea that money today is worth more than money tomorrow, or next year. Would you rather £100 today or £110 from me in a year? Risky - a lot can happen in a year.

The answer is expressed as the Net Present Value (NPV). This is the value over and above the desired return. Any price giving an NPV of zero or more should be worth paying.

Typically 8 – 10 year time period. Sensitivity analysis important – consider a range of possible outcomes.Include assets sellable at termination.

It can be hard to identify the appropriate discount rate (WACC) – sensitivity analysis is important againIt can be manipulated to say what you want to hear (as can most methods).

The maths looks complicated but is quite easy.The numbers to input look simple but are quite hard to pin down.

WACC – think of it like the rate of interest you expect on your savings. If you’ve invested in something, you expect a return. If you have partly borrowed to invest, the return is a blended rate of the return on the shares and the return on the debt.

5) Net asset value (NAV)

• Used for companies in trouble – loss makers, insolvencies, break-even

• Identify the lowest net asset value once losses eliminated and costs borne

• Discount for risk

Tax

• Tax losses – an asset to buyer only if there are profits to offset them. Profits no longer transferable within group, so purchased company must make a profit from trading to use the losses (being broken up is not trading).

• Capital gains – tend to be tax beneficial for sellers, so a buyer who is prepared to buy shares, and their attendant risks, rather than assets, has an advantage over other buyers.

Stories

Value gone – seller with unrealistic expectations throws it all away failing to get a deal

Value found - failure to recognise true worth (lucky he had an advisor!)

Empire builders always overpay

The dilapidations contract disaster – do your due diligence

No income, yet sold for £100m?

Earn out deal, but the buyer went bust!(Due diligence cuts both ways)

Timing matters

PSYCHOLOGY IS EVERYTHING – personalities can kill or close the deal

Expectations management

• Buying or selling a business is complex• Process management is critical, often from

years in advance• Deals take weeks to years to complete, perhaps

10 months +/- many months• Seller needs a trusted confidante to help take

the emotion out of it and retain perspective

“The business is only worth what someone is prepared to pay”

which puts the buyer in a strong position

Process

Valuation is a small part of the larger process of buying and selling a business. For more useful stuff on process see: http://fd4.co.uk/preparing-your-business-for-sale-part-1/

(and part 2)

A solid foundation….Executive Associates David, Neil & Stephen• Set up FD4 in 2012 • Worked together for 30 years• P&G trained in variety of Commercial Finance Roles• Complementary Skills• Finance Directors of major corporations• Worked with, and in, SMEs for last 15+ years

David Cardno

Neil Dockar

“A well balanced team”

Stephen Hill

An Emerging and Growing NeedFor the Client an opportunity for a more “hands on” role than a Non Exec• Proactively lead and maximise the value from the Client’s

bookkeeper / controller and professional advisers• Experience of larger organisations but able to apply those

business principles to the SME environment• Have actually led Commercial Finance teams, not just advised• Higher level skills and experiences needed for one-off

problems / opportunities; bank relationships; improved performance & exit planning.

• Trusted, knowledgeable confidant to SME owners• Access to a wide and varied professional network

And available by the hour on an as needed basis…

Diverse commercial experience

Passionate about adding value to your business

Our experience covers a range of sectors and business experiences :-

David Cardno - founder of FD4, sectors include consumer, b-t-b services and logistics. Business experience covers M&A; Joint Ventures and highly leveraged situations.Neil Dockar - founder of FD4 , ex FD in P&G and Fyffes. Sectors include consumer, franchising, logistics, e-commerce, care homes, financial services and property. Led joint venture & M&A activity. Paul Foster – bio pharmaceuticals and pre-revenue start-up expertise. Fund raising and managing investors / venture capitalists. Intellectual property licensing.Stephen Hill – ex FD in P&G and Volt, Sectors include consumer and B-t-B Services recruitment. Experienced in M&A and running European subsidiaries for US parent.Brian Kilcullen – football club, shipping, private equity and private investment. Bought and sold companies, raised finance, carried out business valuations. Reclaimable energy experience.Robert Sayers – ex FD Farnborough International Airshow. Wide industrial experience most recently in the aerospace, defence and exhibition sectors and complex Trade Associations.Colin Spencer – wide variety of FD roles in marketing and advertising sectors. Chairman Public relations firm. Accredited with various cloud accounting products including Xero and Workflow MaxarentIvor Middleton– science and technology, people businesses, manufacturing, complex business modelling. Helped raise tens of millions of pounds; win large contracts; makes difficult decisions easier.

Passionate about adding valueto your business

Budget & Financial PlanningRisk Assessment Corporate Planning Working CapitalMargin Improvement