Methods of Business Valuation by Their Profitability

Methods of business valuation by their profitability are presented below. They give a vision of the company, which must be supplemented by other approaches to address the "true" price, which will result from the negotiation, i.e., the amount accepted by the assignor and financed by the buyer.

 

 

Summary

Presentation of the profitability method to evaluate a company
Attractions and limits of the method of multiples to value a company
How to conduct a company valuation based on profitability?

Presentation of the profitability method to evaluate a company
A little more technical approach is intended primarily for companies with more than 5 employees.

The general principle of company valuation
The principle of this method is to consider that a company is worth the profitability it generates.

The evaluation is based on the result considered typical of the company:
- as observed in the past,
- or probable in the future.

This result over several years is then valued by discounting, at a discount rate, symboled by i, taking into account the risk that this performance will not be achieved.

Business value = Typical business earnings divided by discount rate
VE = Result / i

In perpetuity: the mathematical formula above supposes taking into account a constant result of the company, year after year, in perpetuity.
We should not be frightened by this notion of perpetuity, used here only for its simplicity of calculation: taking into account, the rates used, the results beyond the 7th year weigh less than the uncertainty on the results themselves.

The discount rate must take into account the uncertainty about future performance. In the same way, we want the money we place in savings to earn interest, we want the cash mobilized to acquire a company to find its reward in its results. And as investing in a company is riskier than a Livret A, it is normal to ask for a higher rate of return.
Noting that 1/i gives a number, we can also say that the company's value is equal to a certain number of times its results. For example, a requested rate of return of 20% per year is equivalent to a multiple of 5 (1/20% = 5)

EV = Result x Multiple

This multiple is similar, by analogy, to the PER (Price to Earnings Ratio of listed companies).

The table below shows the link between the expected annual rate of return in perpetuity and a multiple:

 

x250% per year

Multiple (M)	The expected annual rate of return in perpetuity
x3	33% per year
x4	25% per year
x5	20% per year
x6	17% per year
X7	14% per year
x8	12.5% ​​per year
x9	11% per year
x10	10% per year

We note that the higher the expected rate (in other words, the greater the risk is perceived as necessary, to the point of requiring a substantial "risk premium"), the lower the multiple that will apply and therefore the lower valuation: we buy cheaper which is less safe. Thus two companies with the same level of results but different future performance risks will have different values.

Which results to take into account?
Strictly speaking, the result to be taken into account should be the free cash flow generated by the company, i.e. the cash flow actually available to a buyer to repay acquisition debt, through the distribution of dividends: this is the DCF method (for Discounted Cash-Flows), which is detailed below.

In practice, professionals rely on several results, assessed at different levels of the income statement:

- the gross operating surplus (EBIT or EBITDA)
- net operating surplus (ENE or EBIT)
- the Current Result Before Tax (RCAI)
- Net Income (NR)
- Self-Financing Capacity (CAF) or operating cash flow

For an explanation of the meaning of these "intermediate management balances", see the article "income statement";

As a first approach, the ENE and EBIT couples and EBITDA and EBITDA can be taken as roughly equivalent.
The differences are in the employee profit-sharing and in the extraordinary result, taken into account in the EBIT and EBITDA.

What multiples on results should be taken into account?
Depending on the intermediate management balance used, a different range of multiples must be applied. Professionals, through experience, know the equivalences between these ranges of multiples, of which it is not possible to give a systematic table. An example, however, makes it more transparent:

Example: let's take a company without financial debts or cash, that is to say, without a loan or bank overdraft or a surplus bank account: it does not pay financial expenses. Let's assume that it does not present any exceptional items either (in income or expense) and that its corporation tax rate is 33.33%.

Then the multiples of Net Operating Surplus and Net Income after tax are exchanged according to the following formula:

Multiple of ENE (or EBIT) = Multiple of RN x (1 - IS rate)

 

Net Operating Surplus Multiples (ENE or EBIT)	Equivalent multiples of Net Income after IS for a company without financial debts or cash (NR)
x3	x4.5
x4	X 6.0
x5	X 7.5
x6	X 9.0
X7	X 10.5
x8	X 12.0

This table reads as follows: "a multiple of 6 applied to the ENE (EBIT) leads to the same business value as a multiple of 9 applied to the RN", when this business is taxed on the IS at the rate of 31% for example, and that it has neither excess cash nor financial debts nor exceptional result".

What is the "right" level of multiple?
Obviously, a multiple of 2 or 3 on the ENE (EBIT) is low: according to the table above, the buyer should have recovered in 3 to 4.5 years, the equivalent of his investment ( the cost of acquiring the business) in the form of distributable results (NR).

This level can be adapted to certain activities with extremely variable results or presenting a great fragility or even strongly linked to the manager (certain trading activities, for example).

The limit to such a low offer will be the competition on the dossier and the seller's alternative of continuing his activity: in 2 years, he will have garnered additional income and may still be able to sell the company?

Conversely, a multiple of 6, 7, or 8 on the ENE (EBIT) is high: at constant results, the buyer will have to wait around 10 years before recovering the amount of his investment in the form of distributable income ( the cost of acquiring the business).

These may be companies with both strong results and growth potential likely to shorten the buyer's return on investment period (frequent case in LBO).

It seems to deduce that a multiple applied to the ENE and between 3.5 and 5.5 corresponds to many business situations, which is not false...
What is the influence of the company's financial situation on the valuation?
What happens if the company is heavily indebted or has significant excess cash?

The notation "debt" means financial debts, i.e., non-operating debts. Operating debts are debts directly linked to the company's activity: debts vis-à-vis customers (advances on order), debts vis-à-vis suppliers, tax and social security debts, etc. Typically, financial debts are therefore loans, credits, and overdrafts from banking establishments.

Some Intermediate Management balances already include the presence of financial debt or cash because they take into account the costs or financial income generated. In this case, the value calculated by applying a multiple directly gives the value of the share going to the shareholder:

Shareholder value = x times (RCAI, RN, or CAF)

Other intermediate management balances are independent of the financial structure and do not include the presence of financial debt or cash on the company's balance sheet. In this case, the value calculated by applying a multiple gives the value of the company independently of its financial structure and there remains a little work to determine the share due to the shareholder.

intermediate management rebate

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EBE and ENE

(EBITDA and EBIT)

These balances do not take into account the financial costs generated by the company's possible debt. They are therefore independent of the company's financial situation.

RCAI, RN, CIF

These balances consider the financial costs generated by the company's possible debt. They, therefore, depend on the financial situation of the company.

 

Enterprise Value = Operating Value (x times EBIT or EBITDA)

However, the value of the company is to be distributed between the shareholders and the financial creditors, which is also written:

Company value = Shareholder value + Creditor share value

Looking in detail at the share of creditors, i.e. the amount of net financial debt:

net financial debt = long and medium-term borrowings + short term borrowings - cash

By replacing the terms:

shareholder share value = company value - creditor share value

shareholder value = X times (EBIT or EBITDA) - net financial debt

Shareholder value = x times (EBIT or EBITDA) + cash - financial debt

This method of calculation "sticks" better to the profile of the company according to its two dimensions: its level of activity and profitability (via the income statement) and its financial situation (via cash and financial debts).
This is the preferred route for LBO professionals for quick calculations.

We can see why it is difficult to establish an automatic transition table between the multiples applied to the various Intermediate Management Balances (except in the particular case without debts or cash presented above).

The Discounted Cash-Flows or DCF method
Discounted Cash-flows is often cited by its acronym: "DCF".
The method consists of discounting the company's "free-cash-flow" or "Free Cash-Flow", year after year at a rate representative of its level of risk.

The calculations are theoretically carried out over two successive periods. The first so-called "explicit" period is based on the results projections of the company's Business Plan, generally established over 5 years. The second period covers the future beyond this first period.

The reference business plan can be that of the buyer or a mechanical projection of the company's current operation and its results. It will be necessary to keep it in mind to know what the evaluation obtained at the end of the calculations corresponds to:
- the value that the company could have in the hands of the buyer at the end of the takeover plan
- or the value that the company could have for a "theoretical" buyer who would be able to continue the current activity in the same way.

The "Free Cash-Flow" is the amount of excess cash generated year after year by the company, i.e., what remains of its Self-Financing Capacity (after-tax), after covering the possible growth of the Need for working capital and coverage of the self-financed investment share (i.e., not financed externally by the bank, through leasing, etc.).

Free cash flow = CAF - increase in WCR - investments - repayment of debts + new debts contracted.

Discounting consists of giving financial amounts of the future in today's value. The formula is:
Present Value of a sum S that will be shared or received in one year is = S / (1+ discount rate)

We can deduce that the Present Value of a sum S that will be given or received in N years is = S / (1 + discount rate )(exponent N)

The discount rate is the one that accounts for the level of uncertainty attached to the fact that this sum S will indeed be present. The higher the risk that this is not the case, the higher the rate. This rate represents the expected return requested by an investor in return for the risk he takes in waiting N years to receive the amount S instead of receiving it immediately.

Which discount rate should one use? This rate can be broken down into two parts:
- On the one hand, the part corresponding to time: this is the opportunity cost of not having the money invested, which could have paid off without risk (e.g., around 1.5%).
- On the other hand, the risk premium corresponds to the risk of investing money in this particular company.

For a modest-sized company that will represent the bulk of a buyer's assets (concentration of risk), this risk premium must be significantly higher than that used for a listed company in which we want to integrate a few shares, which will only represent a small part of a heritage.

Thus, a rate of 10% can be considered low and a rate of 30% high (see also the table of rates and multiples above for clarification on this point).

The evaluation of the second period (beyond the 5 years of the Business Plan) uses two methods that have the same root but are expressed differently:

- The method of multiples (see above) applied to the last free cash flow, which implies that the last free cash flow is representative of what the company can achieve in the future (as enjoyed today).
- The DCF method, again, considers a "reasonable" evolution of free cash flow in the future.

It should be noted that the second period should not represent too large a part of the overall valuation (typically less than 30%), for a stable company, whereas it can represent a significant part for a growing company without available cash flow (up to exceeding 100%!). This consideration reminds us that it is not for the buyer to buy a company for the price corresponding to the value he thinks he is able to give it, but for the value, it has for the seller. Today, possibly taking into account the possible progression to judge the interest of outbidding in the event of competition: in other words, the buyer must think of not paying today for the fruit of his own work in the company.

Attractions and limits of the method of multiples to value a company

Attractions

Limits

- Simple and quick to implement

- The value obtained is based on the economic performance of the company and corresponds well to the logic of the buyer

- Allows you to frame the range of values

- Allows having a good vision of the weight of the acquisition debt vis-à-vis the future results of the company

- Buyer and seller can each use the method with their own assumptions

- Does not take into account the value of the assets to be acquired, which can lead to over-valuation by deviating too much from the value of the Net Accounting Assets

- The multiple ranges, although narrow, still has a large amplitude, and its choice is sometimes difficult to justify, as is the choice of the discount rate

- There may be confusion between the different Intermediate Management Balances and the relevant multiples

A little cumbersome to use:
- if the company is not worth much more than its Net Accounting Assets (see patrimonial methods),
- or when the recovery mobilizes little capital (less than 100,000 euros)

How to proceed to evaluate a company by the method of profitability?
Review the "income statement" for the last three years
Before starting his calculations, the buyer must choose the Intermediate Management Balance, which seems to him to be the most likely to reflect the economic value of the company. It may be in his interest to systematically choose the same one in order to compare different recovery opportunities or to be able to refer to a database typical of his activity (scale, etc.)

The buyer must then make corrections, with the aim of obtaining the value that is as close as possible to the economic reality of the Intermediate Management Balance that he has chosen. These fixes are typical:
- the remuneration for the work of the assignor and the members of his family, including elements in kind, to be retained only for their "market" value,
- the amount of the rents if they are too low or on the contrary exaggerated,
- exceptional elements from the past (positive or negative),
- obviously "comfortable" provisions (i.e. not corresponding to any real risk of a charge in the future or of depreciation in the present),
- shortfalls in provisions for recurring events affecting profitability (unpaid customers, inventories, etc.).

These corrections may require a recalculation of corporation tax accordingly (if the buyer has retained an Intermediate Management Balance that takes this into account) in order to have a corrected result net of tax.

If necessary, weigh the three corrected annual results:
This weighting has the effect and purpose of giving more weight to recent results, which are supposed to be more representative of the company's current reality. If the transferee considers that this is not the case, he must then retain the result which seems to him to be appropriate. The weighting is often done as follows:

- 3 to the last,
- 2 on the penultimate,
- 1 to the oldest result.

Then, add the 3 results obtained and divide the total by 6 so as to obtain a "weighted average annual profit" representative of the period of the past three years.

(Corrected result of year N-2) x 1

 

+ (Corrected result of year N-1) x 2 =

+

+ (Corrected result of year N) x 3 =

+

Total

=

Weighted average profit = Total adjusted results / 6

Multiply this "weighted average annual profit" by a multiple
The nature and importance of the strengths and weaknesses identified during the diagnosis of the company must be reflected in the choice of the level of multiple. Does the company benefit from a competitive position, guaranteeing a "situational rent", and whose level of results presents little risk? On the contrary, is the company exposed to broad and active competition without having distinctive assets and can its results be called into question overnight?

In particular, the buyer must ask himself:
- what is the recurrence of performance due to (particularly following the transferor's departure)?
- what is the importance of his own weight in future performance (should he pay today for the fruit of his work tomorrow?)
- what are the objective risks weighing on the operation?
- what level of protection does this activity benefit from? Is there a risk of a major change in competitive conditions in the short or medium term? (opening of a competing business, regulatory constraints, etc.)

By re-reading the tables in this chapter, the buyer should be able to get an idea of ​​what is applicable to the company... and to himself!

Assess cash flow:
If it is ENE (or EBIT) or EBITDA (EBITDA) that has been chosen by the buyer, he will have to determine the cash flow to be taken into account to complete his assessment. By cash, we mean the excess liquidity and investments that the company regularly has at its disposal.

The cash position can vary under the effect of three types of cause:
- the results of the company,
- investments and their financing: the self-financing of the investment reduces the cash flow, the recourse to a medium-long term loan increases it (at the cost of an increase in its indebtedness)
- the working capital requirement: the lag in payments between customers, suppliers, taxes, etc. causes the level of cash to fluctuate.

The buyer should seek to understand the company's cash flow history and the source of its variations, then retain for the valuation the average level which it deems representative. A chartered accountant can support him in this analysis.

Cash flow variations can be seasonal, i.e. follow a particular shape over the course of a year (typical example of the manufacturer of Christmas decorations). Within a month, the dates of the 10th, 20th and 30th of the month lead to significant variations due to systematic disbursements on these dates.

In some cases, the difference in payments between customers and suppliers is to the benefit of the company. As an example, let's imagine a business that pays for its supplies in 90 days and receives cash payment from its customers. In this case, the part of the company's cash corresponding to this mismatch is not really its property, because it will have to settle these invoices in the future. It should therefore not be taken into account in its valuation or at least not for all of it (in particular by answering the question: what is the share of this cash that can really be apprehended to repay the acquisition loan?).
Assess financial debts
Financial debts are made up of a long/medium-term part, corresponding to credits and loans taken out to finance investments. A second part is made up of short-term lines, covering in principle the peaks in Need rather linked to variations in the Working Capital Requirement (WCR).

The valuation of long/medium-term financial debts does not pose any particular problems, since their amount is available in the company's accounts. The valuation of short-term debt uses the same reasoning as that of cash (representative average value).

A little advice from a financial analyst: to check whether the financial situation of the company, as presented in the balance sheet, is representative of the entire year, we can compare the bank debt with the level of financial expenses. If a reasonable interest rate applied to the bank debt leads to the level of financial expenses in the income statement, it is possible that the debt in the closing balance sheet is representative of the average level of indebtedness. If, on the other hand, the financial costs thus calculated are significantly lower than those of the profit and loss account, there is a good chance that the average indebtedness, during the year, was higher than what it is at the end of the year. of the balance sheet.

It may also be useful to identify off-balance sheet commitments, for example, guarantees given by the bank for the benefit of third parties (work completion guarantees, vis-à-vis subcontractors, in the context of export contracts or import, etc.). If the company does not meet its commitments, the bank will have to cover them financially, before turning against the company.

Another way to visualize the valuation of a company: the payback period
Without it being strictly speaking an evaluation method, it can be interesting for the understanding of the buyer to visualize the price in the form of duration (counted in months or years) at the end of which he will have "recovered his bet".

For example: in the case of the purchase of a "right to introduce customers" from a consultant practicing in the liberal profession, the buyer can bring the price closer to the turnover that the customers presented are supposed to get him, possibly by comparing it to the effort in time (and therefore in money) that building up this clientele would require.

Conclusion

In conclusion, in this article, we discussed the Methods of business valuation by their profitability. We hope the explanation was helpful. We would love to hear your notes regarding our blog post. If you are looking for a business valuation report, you can start creating it for free using our intuitive ai based business valuation software.