Valuing a Business
If there is one thing that puts people off buying or selling a business it is not knowing how much any particular business is worth at any particular time.
And it is very sad because there is no magic involved in valuing a business. It is a relatively straightforward procedure, with 90 per cent of it being a simple numbers exercise and only 10 per cent needing some form of ‘value’ assessment.
But as with most simple things in life, there are those out there who just love to complicate and confuse.
The ‘complicators’ are the professional advisers who consider business valuation to be a highly complex science.
The ‘confusers’ are the sales agents and brokers who have an unfortunate habit of making up a valuation theory that delivers the price they are asking without any regard to logic or common sense.
One of the most fundamental skills for assessing a business to either buy or sell is the confidence to make your own assessment of its value rather than relying on other people.
To achieve this, you need to have a thorough understanding of where all these other people are coming from and their objectives. We will discuss this in more detail shortly.
In. the meantime, let’s get down to the nitty-gritty of valuing a business.
NTAs, P/Es and Goodwill
No matter what it is you are thinking of buying you always have in mind two things:
- Is it worth it? (Can I sell it for what I paid if I don’t like it?); and
- What money can I make from it?
If you are buying a car, you check in the paper for prices of similar cars to make sure you don’t pay more than it’s worth. Using this philosophy, you are buying the car at its NTA (net tangible asset) value.
If you are buying the car to run as a taxi you will work out how much you could earn from it to determine how much you would pay. Using this philosophy, you are buying the car at its P/E (price/earnings) value.
You may find that the car is worth $30, 000 but is being sold for $100, 000 with a taxi licence that can earn you $40, 000 a year.
In this case, the NTA value is $30, 000. The P/E value is $100, 000, which is the amount that you pay. The difference between the two is known as goodwill.
You may find that the car is worth $30, 000 but is being sold for $20, 000 because it is the worst taxi in the city and has never made anyone any money.
In this case, the NTA value is $30, 000 and the P/E value is $20, 000, which is the amount that you pay. The difference between the two is known as negative goodwill. (At one stage accountants tried to call it ‘badwill’ but it sounded too much like a heavy metal rock band, so they dropped the idea.)
If you can grasp the simplicity of NTA and P/E then you have cracked how to value a business. More important, you will save yourself a lot of confusion if you understand that goodwill is not an asset at all, nor does it have any value in its own right, but is simply the difference between the price being asked and the NTA value.
This last point may need a little reinforcement.
The world is full of people asking for a goodwill figure for their business. They talk about the goodwill value of their name, their designs, their staff, their contacts etc. Some agents invent arbitrary goodwill figures – one month’s sales, 15 percent of average turnover for the last three years, $500 per customer etc.
Even accountants get in on the act. They often try to sell their practices to other accountants for a goodwill figure of, say, 1. 5 times their annual fees.
For some sellers, it becomes a point of principle, particularly if they were conned into paying goodwill in the first place. ‘I am not selling unless I get $500, 000 goodwill.’
In many instances, you may see goodwill actually on the business’s balance sheet.
In all cases, it should be ignored.
I am not saying that you should not pay goodwill. What I am saying is that it is not an arbitrary figure but is simply the premium (or in some cases the deficit) between the P/E and the NTA.
Let’s look at these concepts in more detail.
Net Tangible Asset Value (NTA)
The NTA is simply the value of the real – or tangible – assets of the business: the land and buildings, stock, work in progress, machinery, vehicles, accounts receivable etc less the liabilities: bank overdraft, hire purchase owing, accounts payable etc.
In order to work out the NTA of a business you simply add up the value of the assets for sale, deduct the liabilities that you have to take over and the difference is the NTA.
The NTA is generally the lowest value set for the business. If you buy a business for its NTA then you are minimising your risk as, in theory at least, if all else fails you can liquidate the business and get your money back by selling off the assets individually.
The only difficulty comes in deciding on what basis to value the assets (the liabilities are not usually a problem).
Valuing Assets
You can value assets three ways:
- Replacement value: how much it would cost to replace everything if, for example, there was a fire. This figure is normally only used for insurance purposes.
- Going-concern value: how much the assets are worth if the business remains profitable.
- Break-up value: how much you could sell the assets for if the business closed down.
Businesses are never sold using replacement value for the assets. They are sometimes sold on break-up value, but only if they are real dogs. More commonly, businesses are sold on the going-concern value of assets.
The other issue is deciding what is a real – or tangible – asset and what is an intangible asset. Once again common sense should prevail. Basically, if you can touch it, it’s tangible. Things called goodwill, recipes, trademarks, patents, formation costs, etc are not tangible and should be ignored at this stage. The NTA is, as the name suggests, the value of the tangible assets.
Price/earnings Ratio
The price/earnings ratio, also known as a P/E, is the main yardstick for valuing a business.
Unless you are completely altruistic, you buy a business in order to earn some money from it. The price you pay for a business is therefore linked to how much it can earn you.
You arrive at the earnings valuation (another term for the P/E) of a business by taking its annual earnings (profits after deduction of your salary if you are managing it) and applying a multiple to this to arrive at the value. That multiple is normally:
- 2 or less for a high-risk business;
- 3 for an average-risk business;
- 4 or more (but not much more) for a low-risk business.
These figures produce P/E values of 2, 3 and 4 respectively.
Now, these figures may seem a bit arbitrary but they do have some basis. If you have money to invest, you have other options to buying a business.
- You could put it in government bonds and earn interest with no risk (as long as you choose your country with a modicum of care!). You would receive interest at, say 5 percent. Therefore, the amount you would invest would be 20 times that interest. This gives you a P/E of 20 (price = $100, earnings =$5)
- You could invest it in blue-chip shares in the sharemarket. You would receive some dividends and you would share in the profits the company makes, which should cause your investment to increase in value. This combined return would give you a P/E of 5 to 15 depending on the quality of the shares you buy.
- Or you could buy a business! If it’s a safe business you would normally pay four times earnings (a P/E of 4). If it’s very risky you would pay only twice the earnings (a P/E of 2), sometimes not even that. If it’s average you would pay three times the earnings (a P/E of 3).
The higher the risk, the lower the P/E, and vice versa.
(Incidentally, when buying and selling private businesses it is much easier to ignore tax when working out earnings valuations. However, the P/E ratios of companies on the sharemarket are always calculated on profit after tax.)
You’ll note that it’s common to use the phrases NTA and/or P/E rather than NTA value or P/E value, which is what is meant.
Now that we have a working knowledge of the mechanics of valuing a business, perhaps we next need to talk about those individuals who are the ‘experts’ – valuers. Coming soon!!
Acknowledgement – this material was published by Keith McIlroy, “Buying & Selling A Business” First published in 1999 by Shoal Bay Press Limited, Christchurch, New Zealand. ISBN 0 908704 51 8
For information relating to valuing a business click here.
