Reasons for valuing a business
A business needs to be valued if it is being bought or sold. Obviously a price needs to be found for the transaction. Expert accountants will often be used to do this. If such a transaction occurs the tax man will likely want his cut at some point, whether it is for capital gains or inheritance tax reasons. Again an expert accountant may be needed to come up with the figures. But we are talking now about civil disputes, and this could be litigation following a purchase or sale transaction, arising because a buyer was misled into thinking the company was worth more than it really was, and might need a credible estimate of what the true value is for the proceedings.
Or it might be a husband and wife splitting up. Their assets might be represented by the family business and perhaps the husband wants to carry on running it but the wife wants a clean break. How do we value the amount the husband should pay for his wife’s share? Otherwise, a partnership might be in the process of dissolution. The partners might want to sell the business to a new owner or some of the original partners may want to keep the business.
Another common example of business valuation arises when a minority shareholder feels badly done to and raises a minority claim under S459 of the Companies Act 1985. The Court might require a value of the minority shareholding so that it can order the company to buy out the minority.
Valuation – art and science
A willing buyer and a willing seller will set a price for a business. But what if the valuation arises because of a dispute? Applying a value to a business then involves areas of judgement which is why different valuers can come up with different values and why valuation is often thought of as an art and not a science. If the business is a quoted company, you can look up the share value in the Financial Times. This will allow an easy value of the shareholding you are interested in. Even then, the value is only what is perceived by investors at any point i time. However, with a private company using a listed share price is not possible. Although forensic accountants may have to value share portfolios (for example when valuing the assets of a person during a confiscation) the vast majority of businesses seen are private companies, partnerships or sole traders.
Valuation methods do involve the use of mathematical formula, but in this area of forensic accounting, more than most, there is also a subjective element. Looking at a number of different methods for valuing businesses it is easy to see why:
- Dividend basis – what is the required rate of return?
- Earnings basis – what is the multiple to apply to profits?
- Assets – how much will they realise in practice – what is a fair value to apply to an asset? Is it worth more in situ and less if sold off?
- Discounted cashflow – what interest rate do we apply, what rate of return is expected, will trading conditions change in the future – is it fair to value on large profits now as we approach a downtrend in a market?
Disagreement can arise in all these, and other, subjective areas. Even choosing which method to use requires judgement. Sometimes a method is set out contractually, for example in the Articles of Association for a company. Sometimes there may well be a method appropriate to a particular industry.
Earnings Based Valuation
This is the most common method used in the majority of cases by expert accountants. We value a business by multiplying an annual level of maintainable profits by what we call the Price Earnings Multiple. Multipling the two together we get the overall value of the business:
Business valuation = Maintainable profits x Price Earnings Multiple
When we look at a business we do not know what the maintainable profits are in the future – we do not have a crystal ball. Therefore we normally look to the past – but at as we know past performance is no guarantee of future activity.
Lets say that the accounts for a fictitious company show £45,000 profit in 2012 and £25,000 in 2013. Which figure do we use? Or do we average the two? We really need more than this. We need to look further back and we need to be sure we know what is happening now and what is likely to happen in the future. The company may say that 2014 profits are going to be £100,000, but are we going to believe that?
Let us imagine this is a stable company and we can see recent performance and future prospects telling us that foreseeable profits are going to be £50k per year. We use our judgement as expert accountants to come up with this figure by looking at trends in the past and patterns of growth. This can be supported by forecasts or business plans the business might have produced. We might average a fluctuating profit to give a better estimate of future performance over a number of years. We might give more weight to recent years when calculating an average annual profit if for example there is a recent trend of profitability.
In calculating this average profit, which is after tax and interest, we will exclude unusual items that might skew the result unreasonably. For example a year might be affected by unusually large bad debts which are unlikely to recur. The accounts may show that the directors are not paid. They must get an income from somewhere and this might be from other companies, such as the parent company. Therefore any valuations of the subsidiary business must take into account any costs borne by a parent company. The accounts might be showing more profit than would be expected if the company was to stand on its own feet.
So we have our profit figure of say £50,000 – what do we multiply it by to arrive at the value of the business. In other words how many years profits do we think the business is worth?
Price Earnings Multiple (PE Ratio)
For a listed company you can look it up in the Financial Times. It is a simple number, a ratio obtained from dividing the current quoted price of the share by the earnings per share (which for a listed company are effectively the distributable profits being paid out as dividends). The quoted price is constantly changing. The market can be volatile, for example towards the end of 2011 one company we were looking at was trading at a share price that gave it a PE of 18. By early 2012 it had risen to 33. This is unusual but it is important to keep an eye on this because in choosing a multiple for our business we will start by looking at PE ratios for similar types of quoted companies. So how do we apply a public company ratio to a private company?
Select a comparable quoted company
It can be difficult to find a truly comparable company because these tend to be much larger than the businesses we are valuing. They are often much more diverse in what they do. Also values of public companies for very large tranches of shares, such as the quarter, third or half shares we are trying to value, are often different to the value quoted for public shares which are held and traded in small parcels. So we will try to find more than one company as close as we can to the business we are valuing. You can see where the subjective process is creeping in.
Some actual sales of private companies are recorded and an average P/E ratio for private companies produced. The Private Company Price Index, or “PCPI”, is produced by accountants BDO. The PCPI ratio is a recognised ratio for valuing private businesses but again there are problems. The PCPI is an average PE ratio for private company deals – usually larger ones where the selling price is around £5 million. So it is still not appropriate for valuing small concerns.
In the end it is the experience of the expert who will use judgement by looking at these other ratios and from experience of valuing other companies and businesses to arrive at a ratio that is appropriate.
All methods are subjective
The PCPI can support the experts choice of multiple. The choice of comparable quoted company or reference to PCPI ratio can and often is challenged. However, the real arguments when valuing a share in a business surrounds the level of discount to apply.
Discount to PCPI or PE ratio
As mentioned we are usually valuing a smaller business than the comparable quoted company or than the average PCPI deal size. Smaller businesses tend to be worth less. Also a smaller private business does not have a ready market. However, we sometimes account for the positive effect of the size of the holding in the business we are valuing being larger than the small parcels of quoted shares that dictate the market value of such publicly quoted company shares. This is a Bid Premium (not a discount).
We now have a figure for future maintainable earnings and a suitable multiple. If we multiply the two together we get the value of the business that has taken account of the performance, size and nature of the business. Unfortunately we now have to consider the size of the holding (the proportion of the whole company) we are trying to value.
If the shareholding is not 100% then we have to consider the relative values of the different holdings of different shareholders. A shareholding of 40% does not necessarily mean that it is worth 40% of the value of the whole company – the value that we have just calculated. The value might be proportionally less because of the lack of control or influence over a business due to the minority holding. This is another very subjective area of the valuer’s work.
We have to consider the voting rights of shareholders, the decisions that will affect a company are made by special or ordinary resolution. Thus we can see that owning less than 25% of a company will give the shareholder very little or no influence for most matters. As the shareholding increases, more influence is gained, until a holding of over 75% will hold absolute control over the business.
There are no text books or market research to support the choice of discount to reduce the value of a minority holding. You have to consider the level of influence, including combined influence of a number of shareholders. Each situation will be different. The Inland Revenue does give some guidance for certain sectors but there are inconsistencies found in this in practice. For example property companies get a greater discount and yet they are easier to market in practice.
To recap the mathematics, we have estimated foreseeable future profits after tax at £50,000 per year.We have identified a couple of traded companies of a similar nature with PE rations of around 15 at present. Using our judgement, experience and the influence of the Private Company Price Index from BDO we think that a suitable ratio for our private company is only two thirds of this, i.e. we apply a 33.3% discount to arrive at a suitable P/E ratio of 10.
Multiplying £50,000 by the 10 gives us a value of £500,000 or half a million.
Let us suppose one shareholder owns 40% of this and we have been asked to value this. 40% of half a million is £200,000.
However, taking into account all the circumstances of control and influence we think that 40% shareholding is not worth a full 40% of the whole value of the company and therefore discount by a further 30% for the minority shareholding, arriving at a value for this share of £140,000.
We have talked about valuing a business based on its future maintainable earning. There are other ways of course. The earnings base requires that a multiple is applied to these earnings and that the most subject part of choosing such a multiple is the discount that we will wish to apply to a similar quoted P/E ratio to take account of the fact we are valuing a private company without a ready market for the shares. Minority discounts to take account of reduced influence for smaller shareholdings.
Experts disagree because the process is an art – it is very subjective in the areas we have discussed. It is an opinion as to what multiple to use, by how much to discount. We are usually trying to value something where there is no ready market, thus the valuation must be hypothetical. Disagreements can also arise however if the expert lacks the experience to apply this judgement appropriately and also if he has a lack of understanding of his instructions and duties. For example it is dangerous to show too much loyalty to the client and inflate a valuation! We can never be hired guns to try and get a better settlement.
There are many different fields of expertise, of course there are medical experts, construction experts, essentially an expert for anything! Some fields are so unusual that it is easy to pick from a small number of practitioners, such as graphologists. Expert accountants are numerous as many disputes are centred around quantum or valuations or incorrect numbers of some sort. They also come in a vast array of guises within the discipline, and it is important that the particular task at hand gets the appropriate expert. We may specialise in civil business valuations that I have been talking about – or business interruption and loss of profits – or asset tracing and recovery (potentially in cross border jurisdiction circumstances) – or fraud investigation – or quantification of assets in cases of confiscation – and many more.
You need to question your expert closely to see that they are fully familiar with the particular area you are dealing with. For instance I would have a hard job attempting to quantify loss of future earnings and structured pension rights in a personal injury case. However, to some of our other forensic colleagues this work is their bread and butter.
Remember a good forensic accountant will question you also. They will want to know the job is within their capability.