In an exclusive Q&A session with Legalwise Seminars, Lauren Cusack, Leader of the Forensic Accounting and Business Valuation team at ESV Business Advice and Accounting, shares some insight into key processes & issues in valuing a business. She will delve further into this topic at the Business Sales: Legal Issues & Risks conference on Friday 12 March 2021.
What is Value?
The relevant basis on which a valuation should be undertaken will depend on the specific circumstances and purpose of the valuation. It is important to define upfront what concept of valuation is being adopted. The basic definition of value is considered to be an estimate of a fair price for parties to exchange an asset.
Premise of value means an assumption regarding the most likely set of transactional circumstances that may be applicable to the subject valuation. The premise of value takes two primary forms:
- Going concern: the entity will continue to operate in its current form after the valuation date; or
- Liquidation or break-up: the entity will cease to operate post the valuation date.
The majority of valuations are prepared on a ‘going concern’ basis. Where an entity is not generating sufficient profits or there is an intention to wind up the business, the liquidation premise of value may be appropriate.
If the entity is to be valued on a going concern basis, the valuer usually adopts one of the following standards of value:
- Fair Value;
- Market Value;
- Special Value or Value to the Owner; or
- Value in Use.
The terms Market Value, Fair Value and Fair Market Value are widely viewed as being synonymous.
Fair Value is defined by the International Valuation Standards Committee to mean the amount for which an asset could be exchanged, or a liability settled, between knowledgeable willing parties in an arm’s length transaction.
Market Value is the most objective or quantitative approach, however using Market Value may understate the real value of an asset if it has strategic importance to particular buyers.
Market Value in Australia is generally defined using the Spencer v Commonwealth of Australia (1907) HCA 70 definition containing the following elements:
- The willing but not anxious vendor and purchaser;
- A hypothetical market;
- The parties being fully informed of the advantages and disadvantages associated with the asset being valued (in specific case, land); and
- Both parties being aware of current market conditions.
What are the main steps in the valuation process?
There are a number of steps that should be undertaken in any valuation process:
- Understanding the Business;
- Determining the valuation and benchmark parameters; and
- Reviewing and cross checking the results.
To understand the business a valuer requires an understanding of the nature of the business life cycle; the business prospects; the business’ strengths, weaknesses, opportunities and threats; and the companies’ strategic and competitive position.
Part of this process involves requesting information and asking questions of management or the parties around key factors for success, historical and forecast financial analysis, undertaking a review of the management structure, determining whether any key person risks exist and reviewing the business plans.
This needs to be coupled with a review of the economic outlook to determine any impacts in the future. Research also needs to be incorporated in the valuation of the industry and markets in which the subject business is operating. Determining the valuation and benchmark parameters requires detailed research and exercise of a valuer’s professional judgement. Consideration needs to be given to growth rates, selling prices and operating cost levels.
Lastly, the sense check has to occur, that is, a valuer should undertake a cross check of their valuation for reasonableness.
What is the difference between Enterprise and Equity Value?
There can be a significant difference between determining the value of a business compared to determining the value of the underlying equity in an entity that owns and operates the business.
The valuation of a business results in a calculation referred to as the ‘enterprise value’, whereas the valuation of the underlying equity in the entity that owns and operates the business results in a calculation known as the ‘equity value’.
The enterprise value includes the value of the business and includes all of the business assets and liabilities.
Net surplus assets are those assets and liabilities of the entity that are not used in the business. Net surplus assets can generally be realised without affecting the earnings of the business and usually stay with the vendor when a business is sold and form part of the equity value of the entity.
The most common valuation error we see is when people confuse the elements of enterprise value and equity value, where debt levels can make the significant difference between the two values.
What are total intangibles, personal and residual goodwill?
The surplus of equity value over net tangible assets reflects an implied level of “total intangible assets”, being the value of:
- Identifiable intangible assets (such as trademarks, brand names, secret formulae, etc); plus
- Residual goodwill
A common misperception is that the total level of implied intangible assets represents goodwill, whereas it may in fact represent the value of a trademark, brand name and/or value attributable to customer contracts or one of many other identifiable intangible assets.
AASB 3 groups intangible assets into the following categories:
- Customer-related assets
- Contract–based assets
- Market-related assets
- Technology-based assets
- Artistic-related assets
What are minority and controlling interests?
A controlling interest generally encompasses the rights, risks and rewards of having control of an entity.
A marketable minority interest represents the value of a minority interest that is freely traded in the public marketplace, for example, the share market. Marketable minority interests in public companies lack control over the affairs of the company but the holder does have control over the ability to sell the investment at will. The marketable minority interest value is generally lower than the value of a controlling interest in the same entity.
A non-marketable minority interest value represents the value of a minority interest in private entities for which there is no active market. Holders of such investments lack control over the affairs of the business and the ability to sell the investment at will. Absence of control and illiquidity results in a lower value than either the marketable minority interest value or the control value.
A synergistic value or interest arises from the combination of two or more entities maximising their performance through partnership, alliance or acquisition. The concept is that the value and performance of the two companies combined, will be greater than the sum of the separate individual parts. The expected synergy achieved through the merger can be attributed to various factors, such as increased revenues, combined talent and technology, or cost reduction. Generally, a purchaser will pay a premium to secure these synergies in their business.
Controlling interests are inherently more valuable than minority interests since a controlling shareholder can control the Board of Directors and Management, direct strategic decision making and access cash flows / declare distributions.
Empirical studies and various evidence exists to support a variety of marketability discounts, control premiums and minority discounts applicable to assessment of controlling and minority interests.
What are the different valuation approaches?
In assessing the value of an asset or entity, several alternative valuation approaches can be considered, including:
- The Cost Based Approach;
- The Market Based Approach; and
- The Income Based Approach
Some of these approaches may be inappropriate, either because there is insufficient information available or the method does not fit the circumstances.
Cost Based Approach
The cost based method is based on the realisable value of identifiable net assets.
It is appropriate to apply when businesses are not profitable, not actively trading or a significant proportion of the assets are liquid e.g. Investment Companies.
Cost based methods include:
- Net tangible assets;
- Orderly realisation of assets; and
- Liquidation of assets.
The net assets method is based on the value of the assets of the business less certain liabilities, at book values, adjusted to market value.
The orderly realisation of assets method estimates fair market value by determining the amount that would be distributed to shareholders assuming the Company is wound up in an orderly manner realising a reasonable market value for the assets (after all realisation costs).
The liquidation method is similar to the orderly realisation of assets method except for the fact that the liquidation method assumes the assets are sold in a shorter period, under a “distressed seller” scenario but is also net of all realisation costs and taxation.
Advantages of this method is that it can be useful for loss making entities and is usually simple to apply but the disadvantages include:
- Does not capture future events
- Difficult to value intangible assets separately
- Tends to represent the minimum fair market value
Market Based Approach
The market based approach estimates an entity’s fair market value by considering the market price of transactions in its equity or the market value and valuation metrics of comparable companies.
Market based methods include:
- Capitalisation of maintainable earnings;
- Capitalisation of future maintainable dividends;
- Analysis of a company’s recent share trading history;
- Industry specific methods; and
- Analysis of purchases and sales of companies
Common errors in applying this methodology include:
- Assessing maintainable earnings, for example, taking a short-term view when earnings are cyclical;
- Assessing remuneration of related parties when the valuer is not a remuneration expert;
- Selecting comparable companies that are not related to the subject company being valued;
- Application of a premium for control, size discount, specific risk discount and/or marketability discount. For example, not allowing for a premium for control when valuing 100%; and
- Applying historical multiples to forecasts and vice versa.
Income Based Approach
The income based approach determines the value of a business based on its ability to generate desired economic benefits for the owners. In this approach, the value of the business is the present value of the expected economic income to be earned from the ownership of a particular business.
Income based methods include the discounted cash flow method. The method is often used to value intangible assets as well as businesses.
The discounted cash flow method estimates market value by discounting a company’s future cash flows to their present value. This method is appropriate where a projection of future cash flows can be made with a reasonable degree of confidence for a period of at least five years. The discounted cash flow method is commonly used to value early stage companies or projects with a finite life. Although the discounted cash flow methodology is technically the most robust, it is highly sensitive to the variables adopted.
Its advantages include:
- Conceptually robust
- Explicitly captures changes in cash flow
- Captures time value of money
- Can be applied across all businesses with cash flow forecasts
Whilst its disadvantages are:
- Difficult to make long term forecasts
- Net present value results are very sensitive to variables used
- Difficult to benchmark
- Most often, small businesses do not have forecasts available for the five years required to undertake a discounted cash flow
- Reliable forecasts can be difficult to obtain especially if past forecasts or budgets have compared unfavourably with actual trading results
I hope these Q & A’s regarding the valuation of a business provide some insight into the key processes and issues that are faced. It is a complex area and with external market factors, such as a global pandemic, the valuation landscape continues to change. If you need assistance with a matter or have a question, please do not hesitate to contact me on 0414 937 967.
Lauren Cusack is the Leader of the Forensic Accounting and Business Valuation team at ESV Business advice and accounting. Lauren is an accredited business valuer and forensic accountant with Chartered Accountants Australia and New Zealand and specialises in advising clients on commercial transactions and litigation matters. Lauren draws upon her financial accounting, business modelling and business valuation expertise to deliver high-quality solutions to individuals, management, companies and legal advisors.
Lauren has been involved in valuing small to medium businesses; private companies, partnerships and trusts; options and other employee entitlements; and intangible assets such as goodwill.
