Evaluate your business for sale? Main methods to consider
For those considering selling a business, the prospect of a valuation may seem daunting. There are several different ways to approach a business valuation, all of which depend on the unique circumstances and characteristics of each individual company.
Harry Parham, Superintendent, haysmacintyre explains what might be the best approach for you and your business It can be helpful to start by understanding the three basic categories that assessment methods fall into.
Similar companies (comparative analysis)
This is a popular method that uses an EBITDA multiple (earnings before interest, taxes, depreciation, and amortization), which is chosen by evaluating the characteristics of a business within the industry in which it operates.
Comparative analysis includes, but is not limited to, projected growth, product or service mix, market position, and how these factors compare to other factors in the industry. The resulting multiplier is then applied to the company’s EBITDA figure to arrive at the enterprise value. Different industries and market conditions produce varying multiples, and the quality of business greatly affects these numbers. Loss-making entities may be valued on a multiple of revenue, a method that is particularly common in the growth stages of technology companies.
Intrinsic value (discounted cash flow analysis)
A more technical approach, revolves around the concept of the “time value of money”: cash now is worth more than cash later. This method involves building financial projections and estimating future cash flows. These cash flows, derived from operating activities, changes in working capital, capital expenditures and debt repayments, are discounted at a percentage that reflects risks, opportunity costs and inflation. The sum of these current values constitutes the intrinsic value.
This approach is less commonly used, except in industries where companies own significant assets, such as real estate. It focuses on evaluating the assets held by the company rather than their business value.
So why is EBITDA important?
Using EBITDA as a key metric in business valuation allows us to evaluate companies on a like-for-like basis. It serves as a proxy for a company’s ability to generate cash, stripping non-cash items from reported earnings. However, EBITDA is not equivalent to cash flow, and there are other elements to consider when evaluating a business including capital expenditures, debt repayments, and working capital requirements.
To improve the EBITDA measure, adjustments can be made to exclude exceptional, non-recurring income or costs, such as an owner’s bonus or a discontinued division of the business. This process ensures a clearer understanding of earnings before interest, taxes, depreciation, and amortization (EBITDA).
Other metrics for business evaluation
While determining a company’s enterprise value is essential, the actual amount a seller receives for his or her stock involves factoring in cash, debt, and working capital. In most M&A deals, transactions are conducted on a cash- and debt-free basis, and are subject to a standard level of working capital.
In the context of a business acquisition, imagine you have £100 in the company bank account with an enterprise value of £50. It is understood that the preference is to receive the full £150 rather than just £50. If a company has a debt of £25 to the bank, the acquiring party inheriting that liability is likely to seek a discount, such as considerations in selling a house with a mortgage.
Beyond cash and debt considerations, the focus shifts to working capital. The accounting definition of working capital is current assets minus current liabilities, which includes cash. However, for mergers and acquisitions, cash is excluded to determine net working capital, a measure that reflects short-term operating liquidity. Net working capital takes into account the difference between current assets and liabilities expected to affect cash flow in the short term. This directly relates to cash tied up in receivables and cash actually provided by suppliers depending on their standard payment terms.
Setting a net working capital target (peg) involves taking into account cyclical fluctuations. Typically, this is based on a 12-month average or sometimes in fast growth scenarios, the previous 6 months or a 6-month forecast. The amount deducted or added to the value of the enterprise depends on the difference between the actual net working capital at completion and the agreed upon assessment. The deficit prompts the buyer to request a discount, while the surplus obligates the buyer to pay the price of the excess. The intention is for the company to leave behind enough funds to continue operations as usual.
In its simplest form, the value of equity can be determined by subtracting debt from cash, then adding the surplus or subtracting the deficit in net working capital. This process, which in practice requires complex calculations, involves negotiations and collaborative efforts from legal, accounting and consulting teams to determine the components of cash, debt and working capital – a process that is not always as straightforward as it may seem.
Appeal to acquirers
The attractiveness of a business to potential acquirers will focus on the strategic rationale for the purchase. Ambitions such as geographic expansion, product diversification, or gaining a competitive advantage can drive acquisition interest.
In addition to the typical advice for improving the business model, strengthening the market position and increasing the operational efficiency of the attraction, it is also recommended to enhance the “quality” of profits, with an emphasis on consistency, growth and diversification. Striving to achieve strong, stable cash flow, while reducing debt, will only increase the attractiveness of the business to potential acquirers.