Businesses are valued to address acquisitions, mergers, shareholding disputes, divorce litigation, admission of new partners, estate administration, etc. Business valuation is judgemental and can be complex. The estimated values can vary considerably depending on methods, data and assumptions used. Value has different meanings. For example enterprise value (“EV”) is the total value of the business assuming no debt while value to ordinary shareholders is EV minus debt.
The most common valuation methods are the market approach, earnings approach and asset approach.
Market approach
This is computed by multiplying a company’s share price by the number of issued shares. This is ideal for listed companies whose shares are traded on the stock exchange.
Alternatively, like is done in the real estate business, the value of a company can be derived from a comparable company whose value is known or whose shares were traded recently. Adjustments are made for differences in risks, marketability of shares, etc.
Earnings approach
A business’ values lies in its ability to generate future financial benefits. There are several approaches to the earnings approach.
Capitalisation of past earnings
Average actual annual earnings (“AAAE”) or Profit, as may be defined, is computed for the past 3-5 years, excluding unusual or non-recurring revenues or expenses. The AAAE figure is then multiplied by a capitalisation factor. The capitalisation factor can be estimated from comparable companies where for example the price per share (“PPS”) is divided by the earnings per share (“EPS”), earnings being profit. For example a public company A with a PPS of $20 when divided by EPS of $2 gives a capitalisation factor of 10. If private company B has average annual earnings of $ 500 000 its estimated market value is $ 5 000 000, ($ 500 000 x 10).
Discounted Cashflow Method (“DCM”)
This method is very popular for business valuations or capital investment appraisals. It can be used in two ways as explained below.
(a) Discounted future cashflows
A business’ future net cashflows for a defined number of years are estimated. They are then discounted using the required rate of return or cost of capital to determine the current Net Present Value (“NPV”). The NPV then becomes the value of the company. This method is especially suitable for businesses with finite resources or limited existence.
(b) Capitalised future net cashflows
The estimated average annual future net cashflows are estimated and their NPV calculated. The average annual NPV is then multiplied by a capitalisation factor, based on comparable companies. For example, if public company X has a capitalisation factor of 5 and company Y’s estimated average annual NPV is $ 1 000 000, then Y’s estimated value is $ 5 000 000, ($ 1 000 000 x 5).
Asset approach
This method is ideal where the earnings or market approach cannot be used. It can be used under the going concern or liquidation approach.
Going concern approach
Assets are valued for example by professional valuers on the assumption that the business will continue to exist. Total asset value is computed minus debt or liabilities to arrive at the Net Assets, in other words the value of the business to ordinary shareholders. This is akin to valuing a deceased estate using the formula “Assets – Liabilities = Distributable Assets”. In a company shareholders own shares, the assets are owned by the company.
Liquidation approach
Assets are valued on the assumption that the business will be liquidated. The total assets, at the lower forced sale or net realisable values minus debt becomes the value of the business.
Combination of methods
Valuation methods can be combined, if appropriate, and a range of values estimated for negotiation purposes.
This article is simplified and for general information purposes only.
Godknows Hofisi is a legal practitioner, chartered accountant and corporate rescue practitioner. He also advises in deal structuring, business valuations and tax. He writes in his personal capacity and can be contacted on +263 772 246 900 or gohofisi@gmail.com
