Valuation is a tricky business! In a world of perfect information all risks are known, alternatives can be compared with certainty and cashflows can be discounted to provide the value of a firm. AI could be used to accurately land on a valuation which accounted for all the factors. It is clear that such perfect knowledge is not in fact available especially for privately held SME firms. In practice the valuation process tends to proceed using comparatives (recent deals completed) and simple earnings multiples.
Multiples of EBITDA or cashflow or even turnover (in some sort of industry rule of thumb such as gross recurring fees) are used as an approximation. Although the price of any one share on the Stockmarket can vary from day to day it is clear that sectors tend to have price/earnings ratios which characterise them. Similarly for smaller private firms different sectors will have characteristics (based on sector’s trends, stability, desirability and prospects) which inform suitable multiples and these are most easily approximated by recent deals completed. Due to the lack of public information and liquidity these multiples used for private company valuations tend to be significantly lower than for quoted companies.
The relative strength of demand and supply determines the value of a firm’s shares freely traded between willing buyers and sellers. One issue for smaller firms is that the deal value is likely to be small so that sales commissions available will reflect that. Thus the quality and quantity of advice that can be give to buyers and sellers, and subsequent due diligence done on deals will mean that most sub-£1m businesses are simply valued using multiples between 1-3X. Of course the difference between 1 & 3 has considerable import for the seller.
Acquirers are basically buying the free cash from a business, ie a seller is selling their profit by multiples of future years. Much of the argument will be around what should be added back or subtracted from profits. Further these figures are probably not in the public domain. The comparison with other firms of similar size is a key way to fact check the claims on either side. USP Data contains the sector information which will be needed to fact check claims made and potential of a firm operating in the sector concerned.
Within any sector there will be winners and losers even if the total market size is static. If the market itself is expanding then all firms can prosper. However in a mature market there is likely to be consolidation whereby growth and economies of scale are sought by acquisition rather than by initiating new customers to the sector itself. This difference in market potential accounts for some of the variation of multiples which it is appropriate to use when valuing a firm in different sectors. As soon as customers are being won directly from competitors the nature of the rivalry has changed and competitive reactions to new sales or marketing initiatives are likely to be stronger.
Once you get over £1m revenues the multiples which might be used for valuations start to creep up. By the time you are at £5m revenues you might expect a business to be getting 4.5-5X. In “Buy & Build” investment strategies it is essential to know which other independent firms are currently operating in the sector to establish feasibility. It is important to know that there is the potential to consolidate enough firms of a particular profile to “move the needle” for the strategy to be effective.
You can see that the act of consolidating firms to make larger firms within a sector has the effect of improving the valuation multiples. Partly this is because of diversification of the risk. Over-reliance on individual employees or directors and/or in a small number of big customers will tend to depress valuations. Valuations will use multiples from the lower of the ranges suggested above if there is too much reliance on either. Also as a firm grows it tends to employ a more formal system which means it becomes less like a job for the director and more like a stand-alone investment with a predictable cashflow and consequently it becomes more attractive as a take-over target.
Within any sector firms approach the actual trading in different ways. Questions of the ownership or renting of premises and considerations of company debt will affect the Net Worth of the business. Indeed some firms will be valued for the assets themselves (perhaps desirable land or machinery) rather than as a going concern. It is important to establish just what assets on the Balance Sheet actually represent using a tool like USP Data. The question is: “does this setup actually confer any benefit to the business to a new owner?”. An alternative way of arriving at a business valuation is to approximate the entry cost. Estimates are made of the cost of developing a customer base and reputation, recruiting and training specialised staff, purchasing assets and licences and developing products and services. In comes down to ignoring the sunk costs and establishing what is crucial to a new business setting up to maximise value for shareholders today.
At the heart of any firm is a “business engine” or methodology which generates the cashflows and which is essentially what is being valued. This typically takes the form of the actual business practice and industry knowledge which is being employed. Take for example the sales funnel. All firms will have one, but how are suspects identified and qualified into leads in a cost effective way by this firm in this sector. In other words what works to drive sales predictably in this sector and what is simply not cost effective. A valuation will be at the high end of any multiple if the “business engine” is successful as exhibited by growth – particularly if that methodology is transferable. Spotting growing firms operating in sectors is key so that comparisons with industry benchmark averages can be done to confirm the rational of economies of scale within the sector.
Sometimes the technology or the capabilities of a particular product will drive the value of the business. The question of “value to who” will be important here since an excellent new product might be snapped up by an industry incumbent either to prevent disruption to existing business by retiring it or to capitalise by using the firm’s own existing route to market. Even within this idea complementary products will appeal to different buyers to different extents especially if they can widen or deepen existing customer relationships which as you know is likely to be where most profitable business occurs.
This brings us to the crucial importance of a thorough analysis of a firm’s customers. In a sense a valuation of a firm can be thought of as the value of acquiring the customer list. The health of this list and its potential is proof of the firm’s potential – and as we have seen in a world of imperfect information such solid verifiable facts are at a premium. A key part of a company valuation will therefore be an assessment of the existing customers. In the case of a trade buyer you will be looking for overlaps with existing markets and new markets that can be reached following an acquisition. Using a tool like USP Data to analyse the customer listing of prospective purchases should be a vital part of a valuation.
With perfect information valuations would be easy. In the real world valuations particularly at the lower end are done typically using multiples of earnings which tend to be sector specific and are lower the smaller the size of the firm in question. Sector information is key to understanding both the potential and existing value of customers and the consequent valuation of the firm itself.