When looking to acquire a business, a purchaser faces the dilemma of how much they are prepared to offer to secure the deal. After all, a purchaser never wants to overpay! Our latest ‘5 minutes with Corporate Finance’ article offers valuation advice to prospective buyers.
However, the valuation process can be complex, and it should be considered as an art, rather than a science.
The basics
There is a lot of talk by ‘experts’ about sophisticated valuation techniques, although in practice, profit is the most consistently used driver of value for most SME businesses. But profit is only one half of the equation, the other being the multiple. Simply put, a purchaser must assess how many years of profits they are prepared to pay for a business.
Profitability – the typical driver of value
Whilst most businesses are valued on a multiple of profitability, definitions of profit can vary substantially. The current preference tends to be EBITDA (earnings before interest, tax, depreciation and amortisation), since EBITDA is considered representative of a company’s cash generation.
However, what actually constitutes EBITDA is also a critically important consideration when it comes to valuation. A purchaser will need sufficient data to assess the “true” underlying maintainable EBITDA – that is after adjustment for one-offs, non-market rate items and costs having longer term benefits. To add to this, for many businesses the calculation of true underlying maintainable EBITDA has been further complicated by the financial implications of COVID-19.
Often a purchaser will intend to implement a raft of changes to the business following acquisition, and in such cases, the profits after making such changes may be the basis for the purchaser’s valuation, not current profits. In other cases, the focus will be on the profitability of existing business, modified only by the planned elimination of surplus or duplicated functions. However, most purchasers will be reluctant to pay away their upside synergies – though in a competitive scenario, this can allow them to be more aggressive.
Multiple debate
Business valuation in the world of SME’s is complicated further, as information involving similar deals is not always available, and metrics such as the price-earnings ratio used for valuing large, listed companies are not directly relevant, so selecting the right multiple to apply to the EBITDA becomes a challenge.
The EBITDA multiple ranges significantly from industry to industry and is influenced by numerous internal and external factors. For example, businesses with high growth potential, a clear brand, long-term contracts, a well-spread customer base and strong continuing management are likely to have higher multiples.
In contrast, businesses which are heavily dependent on the owner, have a small number of customers or are project based tend to attract lower multiples.
Enterprise value or equity value
The valuation debate doesn’t stop there either, as the multiple of profits simply calculates the ‘enterprise value’ without taking into consideration cash, debt and potentially other balance sheet items. In fact, in arriving at the price payable for the shares in a business (the ‘equity value’), the enterprise value is typically adjusted to deduct debt and add surplus cash, subject to a normal level of working capital, and that of course is a whole other topic…
How we can help
The valuation of a business depends on many internal and external factors, which is why business valuation is ultimately an art.
We know getting the right valuation is key to achieve the best possible result for you and your business when making an acquisition.
If you are looking to acquire a business, our corporate finance team, with their wealth of knowledge and experience, can help to simplify the entire acquisition process, including the all-important valuation. Please do not hesitate to get in touch today.
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