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Approaches to Valuing a Business

So in this entry, we talk about the three most used approaches to valuing a business. These approaches are typically used when someone is trying to calculate a value of the business either to attract investment, for reference or sell. Although there are a few more ways to calculate the value of a business, here are the three main approaches used by most professionals.

  1. Net Asset Value Approach
  2. Price-Equity Approach
  3. Free Cash Flow Approach

The above approaches all help us achieve the same thing i.e. the valuation of a business, but take very different approaches using different variables, that invariably result in different figures. The reliability of these figures is another key factor that has to be taken in to consideration too. Here’s a breakdown of the three approaches.

Net Asset Value (NAV) Approach
This approach to business valuation takes in to consideration the total assets and liabilities owed and gives us an indication of what the business value is after all liabilities have been paid off with assets owned by the business.
Some like to use this approach to give them an indication of the business’ intrinsic value, excluding items like brand, customer loyalty etc, which, although hard to quantify, add value in their own way.
This approach works best when business Accountants haven’t tinkered or manipulated asset or liability figures; this is one of the biggest problems with this approach – that it uses variables in the calculation that are exposed to the risk of manipulation and therefore may result in a misleading calculation e.g. Assets could be massively depreciated, or inflated and the same goes for liabilities.
As accounting measures such as assets and liabilities are documented historically, this valuation approach gives us a snapshot of a time that has gone i.e. the last financial year; this is because asset and liability figures are typically sourced from yearly accounts produced at the end of the financial year documenting the year that has just elapsed. You’ll know that this is a problem because if this approach is used to value the business for future purchase, what we’re doing is basing future decisions on information from the past, which is no indication of what the business will be valued at in the future.

Net Asset Value Calculation: (current assets + non-current assets) – (current liabilities + non-current liabilities)

Price/Equity (P/E) Ratio Approach
The approach calculates the value the market attaches to each £1 of the company’s earnings, forming the basis of a valuation if the calculated figure is multiplied by the number of shares.
By calculating the P/E ratio, we can understand that the business may be worth 7x its earnings i.e. for every £1 the company generates, it can attract investment of £7. Therefore, if a business is earning 100,000, this approach suggests that the business could ask for £700,000 as a purchase price.
Now this asking price, as with most things, is relative as we don’t know if this asking price is good or bad, until we compare it with something else. So the next step would be to understand either (a) the average P/E ratio of the industry in which the business operates or the average P/E ratio of a few company that may be similar; both would obviously be better.
As Investors, we always want the P/E to be lower than the average or comparable companies, as this tells us the company is undervalued. The business owner however would always want their P/E to either be commensurate with the average industry figures, or above. If it’s too cheap, this should raise also raise an eyebrow, as something sinister may be going on, which i’ll discuss in another post.
A problem with this approach is that it is fundamentally based on a historical accounting measure (Earnings) that is exposed to the risk of manipulation. By using an earnings figure that has been subject to manipulation, this would skew the figures and not give us a true picture. More importantly however, as we talked about in the Net Asset Value Approach, this approach offers an indication of historic performance and this of course is by no means an indication that the future performance will be as good or bad as historic performance after someone buys the business; it is a snapshot of a given time period that is based on historical data.

Price/Equity Ratio Calculation: Current Share Price / (Latest Earnings / Number of Shares)

Free Cash Flow (FCF) Approach
The FCF approach incorporates future forecasted cashflows for the business that are discounted by a rate of return or ‘discount factor’, bringing future values to today’s value i.e. final figures that are discounted, so they are net present values, after any discounts such as investor rates of return or interest etc. The calculation takes in to consideration (1) future cash flows; (2) required rate of return or a discount factor; (3) any debt outstanding and (4) any outstanding preference shares or portions of the company that are owed to somebody else e.g. Bank holding preference over percentage of some shares.
People tend to consider this approach as the most informative approach to valuing a business, as it gives the investor of the business an indication of future forecasted cashflows, taking in to consideration other important variables that should affect the valuation. Investors like this approach because as per the above definition, the value of the business is the sum of future cashflows, less debts and discount, suggesting that if the future cashflows are zero – is the business actually worth anything?

Free Cash Flow Calculation: Value of free cash flows – Value of debt – value of preference shares

Imagine This:
A company has a government contract contributing to 70% of the business’ turnover for over ten years and the owner decides to sell the business the year the contract ends. With the NAV and P/E approaches to valuation, the investor would have no idea that the contract has ended and how it affects the company’s future. Alternatively, the FCF approach would highlight to the investor that the future cash flows are considerably less, therefore should be purchased for less.

Now this scenario that demonstrates one of the points of value of the free cash flow approach, however each model has its own merits and ultimately offer different information. The NAV approach offers a companies intrinsic value that may be used as part of valuing the business and may be considered a base cost for the business. The P/E approach advises of a multiplier that the company could use to value the business. And the FCF approach advises us of the future cashflow position, taking debt and discounts in to consideration.

My point is that, I don’t think one approach is better than the other. Where I decided to calculate the value of my business, I would use all three and probably more to give me a good picture of where the business is in terms of intrinsic value; market value; future cashflows and then deduce a figure taking everything in to consideration. My opinion is that you cannot value a business using just one of the above approaches and anyone who tells you differently is not doing your business justice. Apart from the above, there are a lot more variables that need to be taken in to consideration including brand, customer loyalty and probably more when valuing a business and this is why I and most of the finance professionals will probably tell you that valuing a business is not a science, but more of an art.

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The Weighted Cost of What?!

The Weighted Average Cost of Capital! Also known as, WACC.

A discussion I had with a friend inspired me to write this post; we spoke about calculating the absolute minimum return a project would need to generate, in order for the project to be deemed feasible.

What is WACC?

WACC is a figure that a company would have to pay to providers of capital in exchange for borrowed capital; sources could be banks, investors, businesses etc.
You would typically use WACC when there is more than one source of capital; where there is only one source, you would not necessarily need to calculate an average, weighted, rate of return, as there would only be one figure/interest rate and that would serve as your WACC.
This WACC is a the return that you must generate as a bare minimum, to at least keep creditors happy and break even.
The assumption however is to generate a return that exceeds the WACC to create a profit for yourself too of course.

Why Would You Use WACC?

You would use WACC to calculate the absolute minimum return you must generate from your project; anything above this base figure is potential profit in your pocket.
The Weighted Average Cost of Capital calculation is also used to decide if whether it is feasible to progress with a project based on the cost of the project against the return on the project.
If for example, the profit, in percentage terms, does not exceed your cost of capital, then the project should be rejected – you wouldn’t be able to even generate an amount that will pay off the creditors! Therefore, do not progress with the project!

Example projects:

  1. You want to borrow money from a number of sources to buy a building and convert them in to single-let flats.
  2. You’re a business that wants to purchase another two retail units and in order to do so, will have to borrow money from the bank and two other investors
  3. You want to stock your furniture shop up and have borrowed capital from one bank and a family member.

Calculating WACC

Right, here’s how you calculate WACC. Let’s say for example you need £200,000 for a building that you want to buy to convert in to single-let flats. The £200,000 includes the purchase price and cost of works. You know four people that will fund your project, either through a joint venture, simple interest based borrowing, bridging loan etc. Let’s say you have four sources for capital and they are as follows:

Source 1:
Source: Bank

Capital secured: £70,000
Interest rate/required rate of return: 8% per year

Source 2:
Source: Bridging Company

Capital secured: £75,000
Interest rate/required rate of return: 14% per year

Source 3:
Source: Hands-off Investor #1

Capital secured: £25,000
Interest rate/required rate of return: 7.5% per year

Source 4:
Source: Hands-off Investor #2

Capital secured: £30,000
Interest rate/required rate of return: 8.5% per year

Note: It is worth noting at this point that all sources have different required rates of returns/interest rates in exchange for the money they’re giving you for your project. The next question is, how do you calculate, in percentage terms, how much you need to generate from your project to pay them all back. I talk in percentage terms because often profits and rates (interest, WACC, tax etc) are presented in percentages (yield, return on investment, return on capital employed etc); this makes them directly comparable. Now the calculation you do is as follows:

nh100 WACC calculation 1

The above calculation is based on the following:

nh100 WACC calculation Illustration

Legend

WACC = Weighted Average Cost of Capital
Source Amount = The amount that has come from one particular source
Total Amount = The total figure gathered from all sources; £200,000 for this example
RoR = Interest OR Required Rate of Return

Calculationnh100 wacc calculation answer

For the above project, 10.26% is the Weighted Average Cost of Capital and the minimum return you would need to generate from your project. Anything above this figure is money in your pocket. In the event, you know, based off other due diligence you have done, that you will get for example, a 23% return on investment for this project, you would deduct 10.26% from this 23%, leaving a tidy 12.74% potential profit for you.

You could incorporate tax in to this calculation by simply adding the tax rate that you expect to pay at the end, but I have intentionally left this out, as I know at this point, creative tax strategies are typically employed to offset or deal with tax more efficiently.

Last note; you may see people differentiate between the cost of equity (your money) and debt (somebody elses money). I haven’t got too complex with this calculation, however you would superficially be able to treat equity (your own money) as a form of debt. This is due to the fact that when you invest your own money, there is what’s called an opportunity cost by investing equity in the project because you could invest that money elsewhere to generate a return and as a result, a rate of return would be required – you could go a step further if a company is using it’s own money and calculate the value of shares + any loans taken by the company and use that as a cost of capital – talk to me for more detail. And lastly, as there is more risk with debt; often this is factored in to the rates of returns.

Last, last note; calculating the WACC can prove to be very useful and is the early stage of an investment/project appraisal, because all this calculation tells you is how much would be required to pay your creditors. The next step would be to calculate if whether the project would be cash-flow positive and this is where discounted cash-flow calculations come in, but we’ll talk about these later though.

Falling asleep now. Hope I haven’t made any spelling mistakes. Good nigt.