At a glance
Businesses are valued in different ways, including discounted cash flows, net tangible assets and cost of creation.
However, the methodology most often applied for small and medium-sized enterprises is the capitalisation of future maintainable earnings (CFME), which includes the often-misunderstood capitalisation rate, usually applied as a multiple.
Much like the Continuum Transfunctioner (the mythical alien device immortalised in the movie Dude, Where’s My Car?), when it comes to the multiple applied in CFME valuations, “... its power is only exceeded by its mystery”.
However, the complexity associated with the multiple in CFME valuations is easily simplified.
The CFME valuation methodology seeks to determine an approximation of the ongoing profit that the business is likely to make into the future (usually by reference to historical performance to some extent), and then applying the multiple.
The multiple, at its core, represents a risk assessment of and for the business; it should consider the industry, the turnover level, the relative financial performance of the business, insurance and credit risk, specific commercial risks, entity-specific risks, reliance upon key employees, owners or key customers, geographic risks, competitor risks and technology considerations to name a few.
A quality valuation enables business owners and advisers to understand the risk profile of the subject business so that they can mitigate the observed risks and thus increase the value of the business.
For example, if a business that is being valued advises that its current geographical location is critical to ongoing profitability but has only a short time left on its lease, a good business valuation should expose this risk as adversely affecting the value of the business.
By providing insight to the business owner and its advisers, a business valuation should offer a roadmap to reduced risk and thus an increased multiple and business value.
Likewise, when a valuation is done well, it should provide some insight about benchmarking of key cost structure performance against industry averages, so that the business can make cost savings in key areas to maximise profitability and again increase the value of the business into the future.
In short, valuations ought not be static instruments utilised for compliance purposes only at a single point in time. They represent an opportunity to truly understand the value drivers of any business, allowing us as advisers to increase the value of our client’s businesses and to leverage off a cost of compliance to truly add value as advisers.