No-one could see this coming
As events in the Australian stock market in July 2013 showed, external macro events can and do have wild impacts on the market “valuation” of an enterprise. For one particular company the political outlook changed and overnight the business lost 40% of its “value”.
How are we supposed to deal with such left field risks in valuations? For the most part it’s not possible but the story underlines how important it is to look ever more closely at assumptions used when valuations are produced and ask what we really know about our target risk profile before going ahead with a decision. In this way we can at least reduce the impact of unlikely events.
Here is some food for thought when it comes to planning your investigation.
Due diligence on steroids
Basic valuation methods are good as they are going to get, but a final valuation number on a report is only a number and prospective purchasers should weigh as much background as possible before writing out a cheque.
Only personal due diligence provides the real stuff for decision-making – an evaluation which supports why you think your hot deal is so attractive in the first place.
What is a business?
Bluntly, a business is just a calculated gamble, a bunch or managed risks. The more risks, the lower the value. We suggest that as insurance against the chance of overlooking some items altogether, doing a lot of homework is the only option. One caution though – avoid analysis paralysis!
1 Start with the basics – use one or more standard valuation method(s) for micro and small businesses
There are four:
· Rule of thumb – the initial ball park estimate based on industry averages
· Net assets – how are the assets valued, are all liabilities included
· Income – evaluate the bottom line prospects and “quality” of earnings
· Market comparison – a detailed comparison with similar business’ values
Aim to reconcile results from chosen methods to produce a final result.
2 Focus on cash-flows
While each of the four options may be more applicable in one circumstance than another, always give heavy weighting to the income method and cashflow statements. The other methods are not irrelevant, far from it, but it’s the future cash projections that really count, and the assumptions underlying them. Cash-flow is king.
3 Now think again. What do you actually get when you buy a business?
A business can be divided into various profiles which can provide new insights into its value:
· The business model (don’t skip this!)
· People related
· Physical (assets, other resources)
· Legal (bank accounts, loans and contracts of all kinds)
· General risk
· The external market
4 Where is the value? What to look for?
A common sense way to value a business is to evaluate its ability to generate and distribute cash dividends in excess of an acceptable return on investment. Any sustainable way of contributing to this goal should form part of the valuation.
The business model – does this business have the makings of something big? Or is it simply a small business. A model determines what the product is, how customers are sourced and reached, how product is distributed. In addition to the basics, consider:
· Does the model allow for a residual structure?
· Is compounding income possible?
· Are operations leveraged by time (employees) or money (external finance)?
· If the model has advantages over the competition allowing superior profitability, are they sustainable? For how long? What’s next?
People – the intangible value of an effective culture. A growing business will involve more than just the owner and there will be employee “goodwill”. Also as part of a community there will be customer goodwill, supplier goodwill and “community” goodwill.
· Will the new owner fit in?
· What happens if a key employee does leave? How much value walks with him/her?
· Is absentee management an option?
· Can the cultural strengths and weaknesses be identified?
· Is it a good company to work with? What are its values?
Physical – what is the realizable value of net assets? Physically a business comprises people and the hardware they use including physical assets, buildings, office equipment, other resources and materials. Assets can be valued on numerous bases, and the value in the books is not necessarily a good estimate of actual realizable cash:
· If the assets include land, what is going on next door? Have development proposals been lodged which will affect value?
· How much cash flow is required for asset replacement?
· What is the physical condition and security of assets used in the business?
· Is there a market for the assets? Sold separately or as part of a business?
· Processes might be considered assets. Are processes well-defined and transferrable?
Legal – what are the paper assets worth. A business is partly a paper structure, comprising financial records and accounts, important legal agreements with customers, suppliers, key employee agreements, outstanding litigation, financial assets and liabilities, credit history, intellectual assets such as trademarks and other paper assets.
· What are the “onerous clauses” and obligations the business is bound to fulfil?
· Are agreements in place to cover known risks?
· What is the quality of accounting books and reports?
· Is the insurance program sensible?
· Are agreements enforceable at reasonable cost?
Pay more than lip service to risks. Events in the stock market highlight how businesses face a situation where remote risks really can eventuate. We suspect lip service is usually paid in this area. Risks should at least be identified and updated regularly. Diversification is always a sensible strategy, where one adverse outcome should not be able to sink the ship.
· What are the major risks facing the company in finance, marketing and operations?
· How are they mitigated?
· Are risks quantifiable?
· How often is the plan updated?
The more risks are reduced the higher the comfort level associated with the business proposition.
Marketing – perceptions are reality. The entity interfaces the world through its product quality, shelf life and succession, comparison with competitor products and organisations, organisational status (“bragging rights”), sustainable competitive advantages (an economic “moat”), favourable trends, the look and feel of operations and more. We suggest that in the 2010’s the marketing plan is the differentiator between businesses. There are so many products and services competing for a customer dollar that no matter how good any one is, if the marketing is not up to speed, the business cannot thrive. Hi growth equates to high valuation. Have a particularly close look the customer acquisition plan:
· Are new customers accessible? How?
· Are they accessible at a profit?
· Are prices stable or predictable?
· Does the business model develop repeat customers?
· Market share – what are the trends?
· Government and regulatory environment – is the industry subject to changing regulations and policies? Will changes affect business?
Finally, bring it all together. What are the strengths, weaknesses, opportunities and threats across finance sources, the management team, and the business’ outlook and forecast?
Are you able to look at the situation objectively?