Continuing our discussion about valuation of software services companies, let’s focus on the market valuation approach.
A central technique under this approach is the comparative transaction method. It is especially useful for valuing private software firms. In a nutshell, the method lets you determine the value of your software firm in comparison to similar companies that have recently sold.
Privately owned software companies with a solid track record of profitability are frequent acquisition targets. You can study the selling prices of successfully closed deals in relation to the financial performance of such companies.
Valuation multiples are the usual tools to estimate the fair market value of your software company using the market approach. For example, you can calculate your company value in relation to its revenues, gross profit, net income, EBIT, EBITDA, discretionary cash flow or business assets.
One of the main advantages of using such valuation multiples is that they are based on actual sales thus offering a highly objective and defensible way to estimate what your software company is worth. This is especially useful if you need to prove your business value to a skeptical investor, or defend your valuation in court or before the tax authorities.
Example – valuing a custom software development company using valuation multiples
We will take a typical contract software development firm with the following financials:
- Gross revenue: $1,300,000.
- Net sales: $1,200,000.
- Gross profit: $1,000,000.
- Net income: $230,000.
- EBIT: $370,000.
- EBITDA: $385,000.
- Seller’s discretionary cash flow (SDCF): $400,000.
- Furniture, fixtures and equipment (FF&E) assets: $450,000.
- Total business assets: $500,000.
- Book value of owners’ equity: $225,500.
We pick a set of reasonable valuation multiples and estimate the value of this software company as follows:
|Business value based on gross revenue
|Value based on net sales
|Value based on gross profit
|Value based on net income
|Value based on EBIT
|Value based on EBITDA
|Value based on SDCF
|Value based on FF&E assets
|Value based on total assets
|Value based on owners equity
|Average Business Value
Each business value estimate can shed a different light on what drives the value of your software company. For example, a high business valuation result based on EBITDA may point out that the company manages its profitability better than the industry average.
An asset rich firm will likely show a higher business value estimate based on the value of its total assets, both tangible and intangible, such as internally developed technology or business processes.
Using business valuation as a strategic tool
Showing how business value depends on your company performance in this way can help you in strategic planning and decision making.
A key question: what value factors can be improved to increase the overall business value? You can focus on the areas that can enhance the value of your company, then measure the result by repeating your business appraisal.
See how a set of 40 valuation multiples can be used to assess the value of a software development firm.
If you own a private mailing business or need to appraise one for a client, here are some interesting statistics to consider:
Mail box rental and shipping companies are classified under the SIC code 7389 and NAICS 561. This business services sector has just under 1,500,000 firms that generate over $301B in annual revenues.
The business services industry segment employs some 3,639,000 people. Yet the average firm is definitely small business: with annual sales of $200,000 and a staff of just 2.
Business valuation methods for mail box rental and shipping firms
Successful private mailing companies sell quite often. You can develop a very good idea of your business value by comparing it to the companies that sold recently. Using the valuation multiples derived from such business sales, you can calculate the fair market value of your business based on its revenues, gross profit, net income, EBIT and EBITDA, the business asset base and owners’ equity.
Example: valuing a mail box rental business using valuation multiples
To demonstrate this market approach to valuing a business, let’s take a typical mail box rental and shipping firm with the following financials:
- Annual gross revenue: $200,000.
- Net sales: $185,000.
- Gross profit: $120,500.
- Net income: $17,000.
- EBIT: $18,900.
- EBITDA: $19,250.
- Seller’s discretionary cash flow (SDCF): $75,000.
- Furniture, fixtures and equipment assets (FF&E): $50,000.
- Inventory: $4,500.
- Total business assets: $61,500.
- Book value of owners’ equity: $44,000.
We next pick a set of sensible valuation multiples to calculate the value of our example business as its potential selling price:
|Price to gross revenue
|Price to net sales
|Price to gross profit
|Price to net income
|Price to EBIT
|Price to EBITDA
|Price to SDCF
|Price to FF&E assets
|Price to total assets
|Price to owners equity
|Average Business Value
Other business valuation methods for private mailing service companies
No business valuation is complete without the use of several methods under each approach: Asset, Income and Market. Since many mail box rental and shipping businesses are owner operated, the Multiple of Discretionary Earnings method is an excellent complement to verify your market value assessment.
Using this well-known income-based valuation method, you can create a comprehensive appraisal based on the business earnings and 14 critical financial and operational performance factors.
If the business has established itself in its market place over many years, chances are there is considerable goodwill. To determine the value of business goodwill, consider using the classical Capitalized Excess Earnings method. Known as the Treasury Method, this valuation technique lets you calculate the value of business goodwill and total company value.
It is highly recommended that you use a number of standard methods to create a solid, defensible appraisal of your company.
When it comes to valuing a business, size matters. The main reasons for this is that companies of different sizes face very different risks. Most investors believe that large companies are less risky than their small counterparts. Other things being equal, the smaller firms need to generate higher returns to compensate their investors for the extra risk they take.
How much more risk? The largest Fortune 500 firms with market capitalizations approaching $500M are about as risky as the overall market. On the other hand, for businesses that are valued well below $150M, the investors currently demand the additional risk premium of around 9.5%. That’s the bracket where most small businesses fit in.
Here are some reasons for this risk perception difference:
- Large companies have better access to debt and equity capital.
- Larger firms tend to be more diversified in their product and service offering.
- Small companies usually have a relatively limited market reach.
- Large firms with deep pockets are often preferred by customers who look for a stable, long-term vendor.
- Large companies have an easier time attracting top management and skilled talent.
How company size affects its value
To illustrate, we will use the well-known Build-Up model to calculate the capitalization rate for a fictitious Fortune 500 company and a small business. We will assume that both firms are debt-free and their earnings grow at 5% per year. Both companies are in the general merchandize retail industry, SIC 5399.
|Small private firm
In this example we have included the company specific risk premium of 4% for both firms.
The valuation multiples above tell a remarkable story: the large company commands the valuation ratio that is almost twice as high as its small business counterpart!
In other words, it takes almost $2 of business earnings for the small company to contribute as much to its value as $1 for the Fortune 500 firm.
ValuAdder gives you a way to assess the company risk for a business of any size. The result is a highly accurate, defensible business valuation.
One of the key factors that affects the value of a company is the industry in which it operates. The question is why and by how much?
The answer is risk. In fact, the industry-specific risk premium is one of the elements that make up the discount and capitalization rates for your business. Here are the key factors that define the industry-specific risk:
- Overall industry growth prospects.
- Barriers to competitive entry such as initial capital investment, license requirements or unique know-how.
- Consolidation trends and degree to which large competitors dominate the industry segment.
- Technological changes that may require considerable investment to stay competitive.
- Regulatory compliance requirements that can suddenly drive up the costs of doing business in the industry.
- Emergence of new competitive threats domestically and internationally.
How much can the industry-specific risk affect the company valuation?
In 2009 the lowest risk industries such as the educational services under the SIC code 82 showed negative industry specific risk premia of around -4%. This means that the companies in this industry sector faced risks below the overall market!
On the other hand, the high risk industry segments, for example the transportation services under SIC code 47, called for the risk premia on the order of 4.3%.
Given the typical discount rates of some 25% for privately owned firms, this could make a difference of more than 8% and greatly affect the valuations of companies in these industries.
Example: effect of industry specific risk on company valuation
To demonstrate the effect of industry risk on company valuations, we will pick two firms with identical earnings forecasts for the next 5 years.
One of the firms is in the educational services sector, the other is a transportation company. To make the comparison easier, we will assume that both firms have the same company-specific risk profile that adds another 4.1% to their discount rates.
Here is the earnings forecast:
- Year 1: $150,000.
- Year 2: $175,000.
- Year 3: 185,000.
- Year 4: 200,000.
- Year 5: $225,000.
Using the well-known Build-Up model, we calculate the discount rates for the two companies as follows:
- Educational services: 18.94%
- Transportation services: 27.47%
We apply the Discounted Cash Flow business valuation method to calculate the value of both companies. Here are the results:
The business value difference is amazing: with the same earnings prospects the educational services firm is worth almost twice as much as its transportation industry counterpart!
See how to use the Discounted Cash Flow method to value a business in any industry.