The debate about how to assess company risk and calculate the discount and cap rates rages on. While the CAPM and Build Up cost of capital models remain widely accepted, the devil, as usual, is in the details.
None as obvious as when using the risk premia for building up the equity discount rates for valuation. There seems no argument among the industry mavens that the risk free rate of return and so-called equity risk premium, or ERP for short, are the gold standard.
Company size premium – does size matter?
With this pretty much settled, the lively debate ensues as soon as you venture into the murky world of company size risk premia. The idea behind this additional element of discount rates is that smaller, less capitalized companies are inherently more risky than the larger, more established competitors.
Big business advantages and size effect on company’s value
Other things being equal, a large competitor is likely to enjoy better access to capital investment, greater acceptance of their products and services by customers, more flexibility in dealing with regulatory compliance (yes, the lobbying does pay off quite often), handsome war chests for fending off legal challenges, and much more.
Market acceptance of established companies is well known. Consider the power of a brand from a major competitor and compare it to a functionally equivalent product from a less known, smaller company. Study after study shows that customers prefer to go with the better known brands from larger companies.
In the business to business space, customers may hesitate to commit to purchases from a new vendor for fear of the company failing and leaving them high and dry without a critical supply. Often the procurement managers would demand to see the start-up’s balance sheet just to make sure they are not going belly up any time soon. The old adage of ‘show me the money’ plays right into the hands of larger, established deep pockets competitors.
Bigger companies also tend to enjoy the economies of scale, unavailable to their smaller industry peers. Ever wonder how come a large software company can come up with a working prototype by lunch time, while a smaller company has to invest ‘all-nighters’ to show similar progress?
That’s because the big company has plenty of talent on board with many pre-existing solutions lying around ready for reuse. They don’t need to reinvent the proverbial wheel, plenty of spare parts ready to be plugged into a new solution.
Smaller companies – trail blazers often fly under the radar screen
As a result, smaller companies often thrive in the netherworld of emerging markets. Big companies are generally not interested in such opportunities until they become large enough to warrant their attention. If and when that time comes, the bigger company usually has the luxury of either making their own competitive offering or buying a start-up’s technology and bringing the key talent on board.
All these and many other factors add up to making the larger companies a safer place to conceive and bring to market new products and services. Common sense tells us that this lower level of operational and financial risk should translate into measurable evidence of lower cost of capital.
Dilemma – when data analysis fails to back the company risk premium
Some financial analysts focus on data evidence exclusively to validate this idea. Smaller companies historic returns must be higher in order to demonstrate their higher cost of capital. The problem with this approach is that if your data analysis fails to show up the difference in returns between companies of various sizes, you would be tempted to assume that smaller companies are about as risky as their larger competitors.
The mindset behind this is ‘if I can’t see it, it does not exist’.
To a seasoned business person this would sound like being asked to suspend disbelief. A pragmatic response would be, ‘if you don’t see evidence of an obvious trait, your analysis is flawed, or you are not looking hard enough in your data collection’.
Can a company value be established based on its gross receipts? In the language of business appraisal this question is addressed by the so-called market approach. Under this approach to valuation you are actually comparing your company to other similar businesses that have sold recently.
You can do such comparison by reviewing the business selling prices in relation to their gross receipts or revenues. The ratio is known as the gross revenue valuation multiple.
Once you have come up with the valuation multiples you can apply them directly to your company’s gross receipts figure to calculate the estimate of your business value.
When is the value derived from the company’s gross receipts a good indicator of what it is worth? Here are the typical situations when you may want to consider using this valuation technique:
Professional practice valuation
Valuation of a rapidly growing company that has not been managed for maximum profitability
Whenever changes are planned that are likely to alter the business costs considerably
As an initial valuation that can be refined at a later date
When the returns and discounts are not significant for the company
Business brokers often use gross receipts as the quick measure on which to base their initial valuation for business clients. This enables them to establish a ballpark number to start with and share with the owners. This number can then be revised as the business selling strategy takes shape.
Be prepared to defend your valuation based on gross receipts as you share your results with others. Investors and partners may question this number based on how they see the company’s profit potential.
In other words, you may need to revisit your business value figure by offering valuation based on the company’s earning potential or its asset base. To do so, you can resort to a number of valuation methods that are based on the business income and assets. In some instances, your results may surprise you and indicate business value that is considerably higher or lower than your figure based on the company’s gross receipts.
The business value equals the cost of recreating an enterprise of equal economic utility.
The idea is that two businesses that generate the same economic benefits for their owners are worth the same.
Note that the asset approach implicitly states that under normal market conditions there is no such thing as an irreplaceable business. For every company, however unique, there is another one that is just as valuable.
If you are in the market to buy a business, you will likely have several candidates to investigate. If your preferred acquisition target does not work out, you will probably move on to the next business down the list. There is always the next best thing in the business market.
Major asset based valuation methods
Asset based valuation approach offers you a number of ways to determine the value of any business. The most common asset valuation methods used in professional business appraisals are these:
The asset accumulation method bears a superficial resemblance to the familiar balance sheet. You create a compilation of the business assets and its liabilities. Next, you assign the values to each. The difference between the sum total value of all business assets and liabilities is business value.
Sounds simple? The devil is in the detail: each business asset and liability must be painstakingly identified. In addition, there should be a way to allocate value to each of these. Some of the line items you may need to work with never show up on the typical business balance sheet: internally developed intangible assets such as patents, trademarks and trade secrets as well as contingent liabilities which may include environmental compliance costs and pending legal judgments.
The excess earnings method is actually a hybrid technique borrowing from the asset and income approaches. In addition to looking at the tangible assets and a set of business liabilities, the excess earnings method also helps you determine the value of business goodwill directly. To do so, the method uses the business earnings as input showing its connection to the income approach.
This unique strength makes the excess earnings method the top choice when valuing established companies with considerable goodwill.
Examples include professional services establishments such as law and accounting firms, medical practices and engineering / architecture companies. The method is also very useful when valuing manufacturing businesses, and successful technology companies, among others.
Excess Earnings Method, known widely as the Treasury Method, is preferred in professional business appraisals whenever the value of business goodwill needs to be established. This is the case for successful services companies, professional practices as well as manufacturing and technology firms. The method is widely used in valuations for divorce.
S corporations are so-called pass through entities. The company itself pays no income taxes. Instead, the shareholders pick up their share of business earnings and put them on their own tax returns. This is big savings compared to the double taxation common with the C corporations.
Pre-tax or after-tax earnings for your business valuation?
When valuing a private company formed as an S corporation, the key question is whether to use the pre-tax or after-tax earnings as your basis. Business appraisers differ in their approach.
One scenario – business valuation for acquisition
An argument in favor of using after-tax earnings in your business valuation is that it puts the S corporation on an equal footing with companies paying income tax. Successful S corporations are often bought by larger competitors organized as C corporations. In this case using a reasonable corporate tax rate makes sense. Note that imputing 35% or higher income tax to the company will certainly affect your business valuation result.
Another case – valuation for buy-sell agreements and partner buyout
A different scenario is a partner buyout valuation. The block of shares is likely to be bought by the remaining business owners who will pay only individual taxes. In this case valuing the company on the pre-tax earnings basis is the right thing to do.
Since S corporations tend to be smaller and usually riskier than their C corporation counterparts, the discount rates tend to run higher. This has the effect of reducing business value even if the company is valued on the higher pre-tax earnings basis.
In most jurisdictions, private businesses are required to pay the so-called ad valorem taxes on business personal and real property. Most business people treat these taxes as a necessary evil – you have to pay them regardless of how well or poorly the company did in a year. You simply have to fill out the local assessor forms about the business property changes, additions and asset retirement, then send in the check.
Interestingly, most assessors do not appraise the business property at its true fair market value. This is a defensive tactic. If a business owner gets a tax bill that shows the business asset values as overstated, he is likely to object to the amount. It is harder to argue if the assessed values are below what the assets are actually worth.
It turns out that the assessed value of a business asset does not matter in so far as the tax bill is concerned. There are two key elements to a business property tax. First, is the assessed value. Second is the overall tax revenue the local government expects to collect. The tax rate is determined based on the overall property valuation and the revenue goal.
So it does not matter if your firm’s assets are appraised at 100% or 50% of their fair market value. The business property tax expense is exactly the same.
Since the tax revenues are split across the entire local asset base, it does matter if your business property valuation is relatively higher than that of other local companies. There are two reasons this may happen:
You have overstated the values of your company’s assets.
The assessor has not properly equalized the value of your firm’s assets in relation to other companies in the area.
In fact, business property tax bills usually do not detail the equalization rate applied to calculate your firm’s property tax burden. The assessor applies the effective equalization rate to all local companies in order to spread the business property taxes on an equal share basis.
The important part to remember is that the business property values and, therefore, the taxes are based on the asset values your company has reported initially. The assessor then calculates your tax bill based on the these initial asset values along with any adjustments for depreciation and inflation.
One point to bear in mind is that the assessor is unlikely to adjust your business property tax for any economic or technological asset obsolescence.
To minimize your business property tax bill, be sure to report the newly added assets at their true market values. As time goes by, make appropriate adjustments to the asset values as property is being used up and replaced.
If you are considering valuation of a company, private or public, the choice of valuation methods may seem bewildering at first. Business appraisers and economists recognize that there are three ways to value any company:
The Asset Accumulation method lets you establish the value of a company based on the tabulation of the market values of its assets and liabilities. Sounds like a familiar balance sheet? Not quite. Using this method you would need to adjust the values of each asset and liability to market.
In addition, the method requires that you include many of the off-balance sheet assets and liabilities such as internally developed intangibles and contingent liabilities. Examples of the former are intellectual property and key supplier / customer agreements. The latter may include pending legal judgments and regulatory compliance costs.
The Excess Earnings method is actually a hybrid with elements from both the asset and income approaches. One of the greatest strengths of the method is the ability to determine the value of business goodwill. The most common implementation of this valuation method is known as the Capitalized Excess Earnings because it uses the capitalization technique to calculate the company’s goodwill.
The capitalization methods use a single measure of earnings and an estimate of company’s risk known as the capitalization rate. The discounting methods take an earnings forecast, usually over a number of years, along with the discount rate. If the company’s earnings grow at a constant rate both types of methods give you identical results.
Market based valuation methods
You can estimate your company’s value by comparison to similar firms in a number of ways:
Using a Comparative Transactions method where the comparison is made against actual business sales of similar private companies. The challenge may be in finding reliable sources of data that can be used for defensible business appraisals.
Applying the Guideline Public Company method. Here you opt for comparisons to similar public firms that resemble your subject company. Since public companies are required to disclose their financial condition as well as major transactional activities, data for comparison tends to be both publicly available and consistent.
Using the Past Subject Company Transaction method. If the ownership of the company being valued changed in recent past, you can review the selling prices of such ownership interests to get an idea of what the company is worth.
Regardless of the method choices you make for your company valuation, the results you get will depend on your assumptions and expectations. It is a very good idea to pick a few methods to make sure you haven’t missed an important point in your analysis.
If you need to determine the value of goodwill of a business or professional practice, the capitalized excess earnings method is an excellent tool. This asset-based valuation method, known as the Treasury method, is especially well suited for goodwill estimation for all types of privately owned companies.
Treasury method uses two rates of return
One important element of this technique is the use of two rates of return in the calculations. One is the so-called fair return on net tangible assets. The other is the capitalization rate used to calculate the value of goodwill from the business excess earnings.
Improper selection of these two rates is perhaps the most common source of errors in business valuation using this method. So it behooves you to choose these values with care.
Choosing the rates of return for your business valuation
Since the excess earnings method looks at the sum total of tangible business assets, it makes sense to use the firm’s discount rate as the fair rate of return.
The idea is that the business owners, acting as investors in their own company, expect the return on the committed capital to be commensurable with the overall business risk. That is exactly what the company’s discount rate captures.
The discount and capitalization rates are related. In fact the cap rate is just the difference between the discount rate and the firm’s expected long-term earnings growth rate.
This being the case, it is reasonable again to use the overall business capitalization rate when calculating the value of your firm’s business goodwill. The Treasury method accomplishes this by capitalizing the excess earnings.
Business goodwill needs to be a finite number
One final note on your business goodwill result. It is common practice to assume that the excess earnings can be capitalized over a finite number of years. So the cap rate should be limited to a number that does not drop below a certain threshold. The typical limits are 3 to 10 years. For example, setting the 10 year limit will give you the cap rate of 10% or greater.
One of the central valuation methods under the income approach is the Discounted Cash Flow technique. To apply this method in your business valuation you would need to work up the following key inputs:
While the future cash flows and business risk assessment usually come from the business financial plan, the calculation of the terminal value requires a leap of faith. The idea is that you can predict business earnings only so far into the future.
You may feel that the business will continue running as a going concern but have difficulty predicting its future earnings. The discounted cash flow method lets you get around this problem by including the terminal value in the calculation. This represents the residual value of the business beyond the earnings forecast period.
There are a number of situations that business owners or their advisors may handle differently in this respect. For example, they may have a clear plan toward selling the business and the kind of money the transaction will likely bring.
On the other hand, the owners may decide to wind up the operations after some time and either sell the remaining assets or use them up prior to the shutdown.
Each of these scenarios may greatly affect what the business is worth today. Other things being equal, the difference is in the terminal value of the company.
If the firm is to continue as a going concern, you can capitalize the future earnings accounting for the expected earnings growth rate and calculate the terminal value.
Alternatively, you can incorporate the future business selling price directly into your valuation. In other words, the residual business value to the current owners is the discounted future selling price.
If the business is to be closed after some time, then the terminal value is just the salvage value of the remaining business assets. If you do not expect significant assets to remain on hand at that point in time, then the terminal value is zero.
Example: Long term planning and business value
Let’s see how these considerations can affect the result of your business valuation. Consider an example company with the following 5 year net cash flow forecast:
Year 1: $95,377
Year 2: $101,231
Year 3: $107,085
Year 4: $112,940
Year 5: $118,794
Note that the average cash flow growth rate for this business is 5.47% annually.
We further assess the business risk and calculate the discount rate of 29.58% and capitalization rate of 24.11%. Next, consider the business value under each long-term scenario as follows:
Case 1: Valuation of a business as a going concern
Here we make the assumption that the company will continue operating as usual past the earnings forecast period. The terminal value is then calculated to be $519,605. Applying the discounted cash flow valuation to these inputs gives us the following business value result:
Business value as a going concern: $397,913
Case 2: Valuation of a business that is sold at the end of the earnings forecast period
Under this scenario, the business owners believe that they can sell the business for $750,000 five years down the road. The resulting business valuation now becomes:
Business value: $460,978
Case 3: Business valuation for a company that is shut down in 5 years
In this situation the business owners opt to close the business at the end of the earnings forecast period. They intend to use up the business assets so that they will have no salvage value then. The company is basically worth the present value of the cash flows expected from the business over the 5 year period. Using the discounted cash flow method again, we get the following result:
Business value: $255,686
Business value depends on your assumptions
Note the sharp differences in the business valuation results we get under these different scenarios. Clearly, the decisions you make today can have far reaching consequences on what the business is worth.
Companies developing security software applications fall within the custom software industry sector. It is classified under SIC code 7371 and NAICS 541512.
Information systems security concerns in companies large and small are a major reason this sector of the software industry has experienced rapid growth in recent years. In 2011, over 49,000 US based firms have been responsible for over $65.4B in total annual revenues. The industry as a whole employs well over 555,000 professional and administrative staff.
Yet the vast majority of security software companies are considered small to mid-size businesses. The average firm produces about $1,500,000 in annual sales with a staff of just 12.
Business valuation of security software development companies
As with any software business, you have a number of well known valuation methods to value security application development firms. These companies are common acquisition targets so you can use the recent business sales as a guideline to estimate the value of a company in this industry.
These sales comparables are an important source of valuation multiples that you can use in calculating the business value in relation to a range of financial performance factors. Here is our short list of valuation multiples to consider:
EV to hard assets such as Property, Plant and Equipment (PPE)
EV to total business assets
EV to book value of owners’ equity
Example: Using valuation multiples for security software company appraisals
Let’s pick a typical firm in this industry with the following financials to demonstrate the technique:
Total business assets: $1,200,000
We next apply the valuation multiples to the corresponding financial performance bases to calculate the business value:
EV to net sales
EV to EBITDA
EV to total assets
Average Business Value
As the above table shows, the calculated values can differ quite a bit. This depends on how our example business financials compare to its industry sector peers. For example, this company appears to be relatively asset rich for its level of revenues and profitability.
You may come across this situation when valuing a private business: the company owns substantial real estate assets in addition to business operations. By convention, businesses are appraised as though the premises were rented rather than owned. If the company owns its premises and does not pay rent to the landowners, you need to factor a fair market rental expense into its income statement.
Consider business and real property separately in your business valuation
This puts the company on an equal footing with its industry sector peers. Remember that business value is defined by business earnings. Since it is typical for companies to lease their premises, you need to consider the effect of this expense on the business cash flow and business valuation calculations, especially with such income-based methods as the Discounted Cash Flow.
What about the business owned real property? You should determine its market value separately, as though the property were put on the market to get the highest and best renter.
The net operating income (NOI) from this arrangement along with the capitalization rate define the economic value of the property. If the business were to be put on the market, along with its real estate holdings, the value of the package would be the sum of business and real estate values, considered separately.
Valuing a business and real estate together
One business valuation method that you can use for your calculations is the well-known Multiple of Discretionary Earnings technique. As you go through your valuation analysis, input the fair market value of the real property along with any other non-operating / excess business assets. The method then lets you calculate the valuation result that combines the business and real estate values.