October 2011: Valuation Misconceptions

What do you say to a business person when asked: “Could you please give me an exact value of my business?” Do you accept the engagement with glee and report back that the business is worth R5602870,38 or do you explain that there is no such thing as an “exact value” and proceed to educate the business person? I have seen valuation assignment rip-offs in practice that would make the Mafia blush.

When performing a valuation of a business one should apply one’s mind to every element of the assets employed in the business (condition, capacity, supply contracts, maintenance contracts, replacement costs, capital budgeting projections, recoverable values, levels, etc.), the rights to other resources (service contracts, lease agreements, royalty agreements, etc,), the obligations and commitments of the entity, the profitability of the business operations, the management of the operations, the staff component and any special skills required to operate, etc. etc. – the purpose of this article is not to give you a checklist but to make a point.

To pretend that accountants have the expertise on every aspect of every business is misleading. What Chartered Accountants do have is the expertise to crystallise all the rights, obligations, projections, etc. into a range of possible valuations of the business. However, this can only be done with the co-operation of the people who run the business. It is essential, therefore, when performing a valuation to sit down with the people in-the-know and understand all the elements of the operations that affect the valuation.

Which brings me to the concept of value. Is “value” the crystallization of what has been achieved in the past or what is expected to be achieved in the future? No knowledgeable businessman will pay a fortune for a business that has performed brilliantly in the past but whose days are numbered because of changed circumstances. Probably 80% of the valuations I see in practice ignore the future and base the valuations purely on past performance. Both the past performance and the future expectations should be considered when performing a valuation (one does not accept the story without analysing the performance) . Here are some examples of what I see:

1. Value = 50% of last years’ revenue

2. Value = 4 times EBITDA

3. Value = 3 times last year’s earnings

4. Value = 2 times book value

5. Value = (3 x earnings) x 30% plus (1,2 x net asset value) x 40% plus (4 x EBITDA) x 30%

The worst valuation I have seen in practice was of a company that had experienced three years of losses where the “valuation expert” took the first two months management accounting profits before tax, multiplied them by six and then multiplied the result by four. He confidently told the client that this was the value of his business!

When I challenge valuation methods that merely focus on some elements of a business’s history, I am told that this is the way business people value their businesses in practice. I am now going to share a secret with you that could make a major difference in your life. I wish that I had adopted this philosophy many years ago. When someone says “everybody does it this way” do not waste time arguing and trying to educate them like I do. Invest time in working out how you can make money out of their stupidity. This is an intellectually stimulating exercise. I will give you a practical example of how this was done in a future article.

Most well run businesses produce budgets and projections. I have found that when I sit with management performing a valuation by projecting the future free cash flows using the du Pont financial analysis system (I project the ratios and the models calculate the amounts), management start to understand how, by focusing on key value drivers, they can maximise the value of their business. The valuation models become a budgeting tool which has as its goal not “net profit” but “fair value”.

During a lecture on valuations to a class of TOPP students at a listed company I said that the approach one should use when valuing a business is to project the future free cash flow expected to be generated by the business and to discount this cash flow at a fair risk adjusted discount rate. One of the participants yelled: “No one can tell the future.” I replied: “Now you understand the concept of value.”