Valuing a business is made even more complicated by the variety of approaches to choose from
A company’s share value is always subject to much discussion among shareholders and investors. As the Dutch saying goes: “Value is what the next idiot will pay.” In fact, this is what we call price and price is not a synonym for value.
Value is a complex concept. It exists in the mind of the individual and is completely subjective in relation to the expectations and wishes of that person. For example, a car enthusiast may value a vintage car very differently to a normal motorist. Trying to objectify that value isn’t easy.
Walking in the buyer’s shoes
In the case of a corporate transaction, one must try to empathise with the potential buyer and put oneself in their shoes to understand the assumptions and expectations they might have for the future cash flow of the business. This will give you an insight into the value of the object to the buyer and, in turn, the price they might be willing to pay for it. A buyer will never purchase an object for more than its perceived value, but they might use it as a guide to the maximum amount they would be willing to pay.
Take, for example, a transportation company that is interested in buying another transportation company. The target company may hold a strategic advantage for the buyer if, for instance, the buyer’s routes are adjacent to the routes of the target company, offering potentially substantial cost reductions in future years. If the potential buyer is a financial investor, it will be more difficult to achieve the same cost reductions.
Return versus risk
Another important question is how to calculate the return the buyer will require on an investment with a business-specific risk? A popular method is to use the capital asset pricingmodel. This portfolio theory was developed in the 1960s and takes the risk-free rate as a basis. In the Netherlands, one usually takes the interest rate at the time of valuation of ten-year Dutch treasury bonds, which are considered as risk free as you can possibly get. A market risk premium is added, which accounts for the additional return shares have yielded on top of the risk-free rate. According to research by McKinsey, this varies between 5% and 6%. As some market can be more volatile than others, a correction is made to take account of the market risk premium, which is known as Beta. The Beta is multiplied by the market risk premium giving you the cost of equity.
If the business being valued is small or has specific risks then these will also need to be taken into account. Many firms carrying out valuations will offer an additional, statistically generated, specific risk premium, based on the size of the business being valued or other characteristics. These will also be part of the cost of equity.
The build-up model
Another method often used in the valuation of small and medium-sized enterprises is the build-up model. This method embraces the subjectivity of valuation and instead of trying to objectify the cost of equity, analyses the company’s ability to operate independently. It builds on the same risk-free rate and market risk premium, but rather than including Beta and specific risk premiums, breaks down the dependencies of the company and assigns a subjective value to the perceived risk. Those perceived dependencies are ideally incorporated into forecasted free cash flows, for example, in the form of scenarios. Of course, professional judgment is needed to ensure that this is within certain limits.
The cost of equity will always be open to discussion, but this is preferable to putting blind faith in an outcome by using formulas calculated into double-digit decimals.
Using multiples of EBIT or EBITDA are useful tools to put your valuation in perspective. If your outcome from commonly used valuation methods differs significantly from the multiple outcome, there could be an error in your valuation. On the other hand, sector multiples originate from prices and negotiations and do not incorporate the intentions of the proposed buyer – rather, they incorporate those of previous (and perhaps completely different) buyers.
Chartered valuers in the Netherlands are highly trained professionals who are qualified to perform business valuations.
This article has been published in the Nexia Global Insight newsletter, April 2014.
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