UNDERSTANDING VALUE
Élan Corporation plc was the first Irish business that I remember having an extraordinary valuation. For those of you too young to remember, it was a Pharmaceutical business “founded in Ireland by American businessman Don Panoz in 1969. In the late 1990s its value on the Irish Stock Exchange reached over €20bn. However, in 2002 an accounting scandal and investor reactions to the global slump, caused a major devaluation resulting in a share price slump of over 90%” (Wikipedia).
Just to put €20bn in perspective, if you stacked €20bn worth of €2 coins on top of each other it would only reach about 2/3 of the distance to the moon. That’s a lot of value. When it slumped by 90%, the stack of €2 coins would have dropped to the distance between the North & South poles of the globe. Elan ultimately merged with Perrigo a business currently worth in the region of $6bn. Perrigo is in the news recently as it lost its action to overturn a €1.64bn Irish tax assessment.
Perrigo has Revenues of approx. $5bn, GP of $1.8 (37%), Operating income of $200m & Net Income of $146m. Could operating income of $200m be driving value of $6bn? The answer is no, the value is in the assets the business has. More accurately the value of the balance sheet (net assets) which is about $5.8bn.
Do you know the value of your business? Is the value in the income you are generating now, the potential for the business or is it sitting in assets you have created up to now?
You should know the value in your business and what drives it. Keeping this to the forefront of your mind will help you make decisions to build a sustainable business.
There are a number of things to bear in mind when considering value. The type of business and basis for the valuation, the multiple in an earnings valuation and then for growth businesses the difficulty of valuing the future potential.
Type of Business & Sectors
The most straight forward form of company valuation is an asset valuation. We look at the balance sheet and assuming the assets held by the company are at market value then the balance sheet value should represent the value of the business. This is appropriate in businesses that have relative low trade in the business compared to the assets held. A property holding company is a good example of this.
Some sectors use easy to calculate measures of value. The sectors do this because there is enough activity in the market to generate benchmark measures. An example of this is the accounting profession where practices sell in the region of one times turnover. Another is grocery shops that used to sell based on a multiple of weeks turnover (e.g. 35 times). Retail pharmacy used benchmarks of between 1 and 2 time turnover. I looked at a valuation last week of a medical services business and the valuer referenced 1.5 times turnover as the basis. Hotels are often valued by room – e.g. €100,000 per room.
These types of measures are notoriously inaccurate and ignore profitability. Purchasers were happy to just pay for the turnover, assuming that once they applied their own model to the purchased business, they would be able to generate their usual profit.
For typical business in the normal economy it is common practice to look at a multiple of earnings to value a business and adjust for anything unusual in the business, like significant assets, extraordinary costs or other items. E.g. if a business makes a profit of €500,000 p.a. and we are comfortable with a 6 times multiple then the value is €3,000,000.
In an earlier blog post I discussed profit in detail. What profit figure to use in a valuation is hotly contested in the valuation world. Des Peelo in his book ‘The Valuation of Businesses and Shares: A Practitioner’s Perspective’ strongly advocates net profit after tax as the key profit figure to use while in practice EBITDA (Earnings Before Interest Tax Depreciation and Amortisation) is still widely used.
Price earnings multiples in public companies are well regulated but in private, closely held, owner managed businesses multiples of a profit figure that equates to operating profit or EBITDA is still used. The reason we take out Depreciation, interest and tax is because they relate to non-operating costs and they vary depending on historic circumstances, financing arrangements and tax regimes.
We are interested in looking at the profit that the business generates from normal operations and in family businesses or other closely held companies we often have to make adjustments for unusual directors salaries or costs that a purchaser would not have in their business. This normally helps the valuation.
For those of you who have come across valuations of businesses, you may have seen Net Present Values being used. There are good reasons to use discounted cash flows (DCF) to generate a valuation for a business and I have often used this method to demonstrate what a scaling business could be worth. In truth, DCF models are useful for financial analysts that are comparing potential acquisitions or investments but in private (SME) I have never seen a DCF to generate a reliable valuation. If you’ll forgive me for getting technical for a moment, a key element of the DCF is the discount factor and picking a discount factor is highly subjective unless you have access to large amounts of market data.
Bringing this together, we can be fairly happy that a good basis for valuing a company is to take an adjusted profit which we could describe as maintainable earnings in a business and multiply it by a figure (the multiple) to get the valuation. The multiple does vary from transaction to transaction but there are some reasonable guidelines we can use.
Multiple in an earnings valuation
Getting comfort with the right profit figure can be difficult but once we have established it then the biggest determinant of value is the multiple we apply to the profit. A good position to start with is a multiple of 6. This is a very rough multiple that will give you a base for what a reasonable business with normal growth potential could achieve.
We do see multiples of less than 6 particularly for businesses that are heavily dependent on the owner for success. The lower multiple is allowing for the risk of the business falling away post acquisition.
We see many multiples well beyond 6 and the BDO UK Private Company Price Index for Q3 2020 has reported an average EBITDA multiple of 10.6 times on 338 transactions. The work of the valuer is to establish what multiples are present in the current market, for that sector, for a particular size of business and then allowing for other circumstances.
The circumstances will have a significant effect on value. If we are valuing for tax purposes or other situations where an open market transfer is not taking place then assumptions are documented and the valuer takes a position with consideration for hypothetical circumstances.
If there is a transaction in play then the circumstances will play into the real price and ultimate value. Special purchasers have a significant impact on value when they have a particular personal reason for the purchase driving up value. Market enthusiasm or fears can have a dramatic impact on value and there are many sellers who thank their lucky stars that they got their business away before an economic crises or other external event.
The multiple will reflect the conditions at the time of the valuation or transaction.
Valuing future cash flows
Growth companies require a different approach for valuation. When a start-up or company that is growing aggressively is raising funds then it is issuing shares in the company to fund the growth. This is entirely different to owners of a business selling their shares to exit the business. The investor is looking for a return on the investment by allowing the company to use her cash to execute the business plan. The return will only come for the investor if the company is bought out or goes public (IPO) sometime in the future.
While there is a significant amount of science that goes into valuing growth businesses, in-truth there is a very large gamble at play and professional investors play the numbers to get the return. Venture Capitalists or other similar private equity investors will look at 100 busines plans and invest in 3. To get a significant winner they will need to invest in 10. Out of the remaining 9; 3 will fail quickly, 3 will bump along and 3 will do ok.
For high risk investment, the investor will want to see the possibility of a 10 times return. While they don’t expect it to happen necessarily, they are looking for that possibility. The business plan for a growth business needs to show significant potential to be of interest to the VC market.
It is understood in these types of investments that there is no point taking too much equity from the owners at an early stage as subsequent rounds will dilute the founders and it is important to make sure there is enough in it for founders to keep driving the business in the early years.
For this reason it is uncommon to see private equity investors taking more than 20%/30% in an investment round. Considering many early stage private equity funds have minimum investment levels of €2,000,000 this means that early stage (post seed) company’s will have valuations of €6M to €10M minimum. These businesses may only have 10 to 20 employees and low revenues. It’s not about what the business is doing to today, it’s all about the future.
Valuation in these situations is sector specific. It’s often a ‘land grab’ for customers in a new space. You may have heard of the concept of a Unicorn; a startup / early stage growth company which is privately held and has a valuation at over a US$1 billion. There are 495 in the world (Nov 2020), led by the USA (136), China (120 & India (35).
All Unicorns start with the first pitch and probably raise small amounts of money to validate the idea. In Europe we have a less developed funding market willing to put significant funds into early stage companies. In these circumstances founders don’t walk away with the funds so the valuation is conceptual but necessary in the ownership models we use.
It’s quite incredible how valuation has changed in the twenty years since I started working in the space. GE was a giant 20 years ago with a Market cap of $500bn, today GE’s market cap is $85bn. Tesla with a market cap of $480 billion is greater than nearly the entire established Auto industry! Stripe founded by Limerick/Tipperary brothers, the Collisons has just completed another funding round pushing the business value to $100 billion, all in the space of a decade.
You should have an idea of what your business is worth now and a target of where you want it to go. If nothing else this will help you understand whether you have a lifestyle business or something with significant future potential. Both are good, but for very different reasons.
(Photo Hans Eiskonen)
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