[caption id="attachment_29387" align="alignright" width="252"] Dada Adefolami[/caption] By Dada Adefolami Business valuation is a process and a set of procedures used to determine what a business is worth. In finance, valuation is the process of estimating what something is worth. Items that are usually valued are a financial asset or liability. Valuations can be done on assets (for example, investments in marketable securities such as stocks, options, business enterprises, or intangible assets such as patents and trademarks) or on liabilities (e.g., bonds issued by a company). Economic conditions affect what people believe a business is worth. When jobs are scarce, more business buyers enter the market and increased competition results in higher business selling prices. The circumstances of a business sale also affect the business value. There is a big difference between a business that is shown as part of a well-planned marketing effort to attract many interested buyers and a quick sale of business assets at an auction. Earnings & profits (E&P) is the measure of a corporation’s economic ability to pay dividends to its shareholders. An up-to-date E&P calculation is important for many corporate transactions, including determining whether a distribution to shareholders is a taxable dividend. The two main methods of valuing a trading entity are the earnings-based approach or assets-based approach, although other methods suitable for a business trade or circumstances are also available, the discounted cash flow approach. Ownership is important so when valuing an interest that is less than a 100% interest, it may be appropriate for that interest to be discounted from the full pro rata value. Earnings-based approach What multiple SHOULD APPLY to the earnings? Price/earnings ratios (P/E ratios) are calculated by reference to post-tax earnings. A P/E ratio is the relationship between the post-tax earnings of a business and its capitalized value. For example, if a business is earning N100, 000 per annum post-tax and is sold for N1m, then the business is said to be sold on a P/E ratio of 10. As an alternative to a P/E ratio, an earnings before interest, taxation, depreciation and amortization (EBITDA) multiple can be used. Also, turnover multiples can be used in certain circumstances, such as professional practices. Making an adjustments to earnings When valuing a standalone business, historic and future earnings can be affected by any one-off, non-recurring or other abnormal entry. Some common examples are as follows: 1. Directors’ remuneration not at a commercial rate. 2. Bad debts either unusually large or small. It may be that the company has income from other sources (such as rental income) which is not part of the core business activity to be valued. If the business is valued on an earnings basis, then the income from other assets is removed from that computation and the value of the relevant assets are added to the final valuation. If the company is part of a group then there are additional factors which need to be considered, including the following more commonly seen issues: 1. Intra-group trading needs to be on a commercial and arm’s-length footing. 2. Intra-group financing needs to be on an arm’s-length basis with appropriate interest charged. 3. Intra-group charges such as service charges, directors’ remuneration and the like need to be on an arm’s-length basis. 4. Intellectual property rights owned by one Group Company and used by another should result in an appropriate license fee being charged. Some trading companies hold assets with a considerable value, such as property developers and farming companies. The minimum value for such companies is likely to be the sum of the assets that they hold. It may be appropriate to add to that minimum value a further sum representing goodwill. Assets-based approach Asset-based approaches should be considered where either the business is loss-making, is making a very poor return on assets or is in a break up situation. If the company is loss-making but can still be considered a going concern, the valuation should adjust any material assets to reflect current market value. A discount to the net asset value may be appropriate to reflect the likelihood of losses in the future. If the company is only making small profits compared with the net asset value, and the application of a P/E ratio or other multiple will produce a value less than the adjusted net asset value, then the valuation would normally be based on the net assets. No further discount would normally be required to reflect future losses. If the company is in a break up or other distress situation it would normally be assumed that creditors need to be paid in full, but assets would be reduced in value to reflect the fact that the company is in distress. In some cases it will be necessary to engage a valuer to value material assets such as property, plant and machinery, intangible assets, growing crops and livestock. Contingent tax liabilities may need to be brought into the valuations. The following issues need to be considered in deciding how much of the contingent tax charge should be deducted: 1. When an entire property company is being sold, the vendor and purchaser often begin negotiations on the basis of a 50:50 split of the contingent tax between themselves. 2. When the company owns many properties and is regularly engaged in disposal and replacement of properties, then a large percentage may be appropriate. 3. If the company owns a single commercial property and has no history whatsoever of property disposals, then it might be that only a very small proportion of the contingent tax would be deductible. 4. When negotiating valuations with Revenueauthority, an appropriate allowance will be provided. [caption id="attachment_29387" align="alignright" width="252"] Dada Adefolami[/caption] Ownership Discount factors need to be considered when the interest is less than 100%. When valuing an interest in a private company that is less than a 100% interest, it may be appropriate for that interest to be discounted from the full pro rata value. The level of the discount will depend on various factors, including the size of the interest, the spread of other interests, the degree to which the shareholding is locked in and the pattern of dividend payments, both historic and going forward. The following ranges of discounts are often reasonable: 1. Over 50% interests: a discount of 5% to 10%. 2. 50% interest: a discount of 15% to 25%. 3. 26% to 49% interest: a discount of 30% to 40%. 4. 10% to 25% interest: a discount of 45% to 55%. 5. Less than 10% interest: a discount of 60% to 75%. a. Discounts for size may be minimal for shareholdings in excess of 75% and be small say 10% for interests of 51% to 74%. This reflects that at 51% and above, the interest controls the company and an interest of 75% and above can pass a special resolution b. The discounts for 50% interests will often depend on the nature of the other interests in the company. If the 50% interest is faced with a single other 50% interest, then a large discount perhaps 25% may be appropriate. Where the 50% interest is the single largest interest, and the other 50% is held by a number of small shareholdings, then the discount may be reduced to say, 15%. In a position where the 50% interest has a casting vote, then this is in effect a majority interest and should be discounted accordingly. Sometimes an interest has strategic value for example, 10% held and only two other interests of 45% each exist in a company. Then the interest may have considerably more value than it would in normal circumstances. Where the valuation is for the purposes of a dispute or divorce, then the discounts of the order of those shown above are likely to be too high, and even for small minority interests a discount of no more than say 33% may be appropriate. The Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, limited period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company’s value and situation. Cash flow can be used, for example, for calculating parameters: it discloses cash movements over the period. to determine a project’s rate of return or value. The time of cash flows into and out of projects are used as inputs in financial models such as internal rate of return and net present value. to determine problems with a business’s liquidity. Being profitable does not necessarily mean being liquid. A company can fail because of a shortage of cash even while profitable. as an alternative measure of a business’s profits when it is believed that accrual accounting concepts do not represent economic realities. For instance, a company may be notionally profitable but generating little operational cash. In such a case, the company may be deriving additional operating cash by issuing shares or raising additional debt finance. Cash flow forecasting or cash flow management is a key aspect of financial management of a business, planning its future cash requirements to avoid a crisis of liquidity. Cash flow forecasting is important because if a business runs out of cash and is not able to obtain new finance, it will become insolvent. In finance, the beta (â or beta coefficient) of an investment indicates whether the investment is more or less volatile than the market. In general, a beta less than 1 indicates that the investment is less volatile than the market, while a beta more than 1 indicates that the investment is more volatile than the market. Where the company documentation or a shareholders’ agreement specifies how the shares are to be valued, then these should be followed. For non-trading companies such as property companies, the discounts for minority interests tend to be lower than the discounts appropriate to trading companies Business value used to determine what a business is worth to a particular investor or business owner. Also, measure of business value that reflects an investor’s in-depth understanding of the company’s true economic potential. You can choose the intrinsic business value standard if you seek to determine the business worth based on solid understanding of the business fundamental attributes. The knowledge allows you to develop a comprehensive estimate of business value based on what business ownership benefits can be achieved. These benefits are tied to a number of key factors such as: 1. Business earnings potential. 2. Likely business growth. 3. Company’s financial and operational strength Choosing a different basis of value may lead you to a different valuation result. For example, an investor focused on building a diversified portfolio of companies may value a business differently than an entrepreneur interested in a specific business opportunity. Prepared By: Dada SurajuAdefolami, Professor of Finance, School of Business Administration. UNEM University, Costa Rica, is a Finance / management Consultant and Certified Forensic Accountant. You can reach him via: surajudada@yahoo.com: 08052043855