Business Valuation
January 2022
This article is intended to give you a simplified explanation of how businesses are valued. It is not intended to provide a full explanation of this very complex area. Always contact a professional business valuator and/or your Chartered Professional Accountant to discuss buying or selling a business. You can find a Chartered Business Valuator here.
Basic Concept of Business Valuation
Let us assume that you can earn 5% on an investment that has no risk; for example, a term deposit at the bank. Now, assume that you are approached by a wealthy individual who says, “I offer to pay you $1,000 per year for the rest of your life. This is a guaranteed payment. How much will you pay me for the privilege of receiving this $1,000 forever?”
If a bank was paying an interest rate of 5%, you would need to place $20,000 on deposit to receive $1,000 per year from that bank. In other words, it would cost you $20,000 to obtain that privilege of receiving $1,000 per year. Therefore, if the guarantee by the wealth individual was as good as the bank was offering, then the price (i.e. value) that you should be willing to pay that wealthy individual is $20,000.
Business valuators turn this interest rate calculation upside down and call it a “multiple.” At an interest rate of 5%, the principal to be invested is 20 times the interest rate – determined by dividing 100% by 5%, which gives you a a multiple of 20. If you want interest of $1,000 per year, and the current interest rates are 5%, they apply a multiple of 20 to the $1,000 to reach a value of $20,000. If interest rates were 10%, the multiple would be 10, and the value of receiving income of $1,000 per year would be $10,000. However, using bank rates assumes very little risk is involved.
Building in Risk Factors
However, what if the payment was not guaranteed? If the risk-free rate is 5%, you would want more than 5% to reward you for taking extra risk. Valuators consider various factors to choose an appropriate interest rate to apply to a business. For example, a long established business with regular earnings is less risky than a new business with fluctuating profits. Interest rates ranging from 15% to 25% are typical. In all cases, the determination of an appropriate rate starts with the risk free rate available today, which is usually based on the rate paid by long-term Government of Canada bonds, and then increased for various risk factors. What kind of risks is the business exposed to? You want a higher rate of return if the company has a higher risk of failure in the future. Note that valuators use the term “discount rate” instead of “interest.”
Capitalization of Maintainable Earnings
Based on the above analysis, if you were looking at buying a business, you would first want to know the amount of profit that it can generate on an annual basis. It really does not matter how much the business earned in the past – it is the future profits in which you are interested. Sometimes you can look at historical performance to estimate future profits; in other cases, you look at future projections. Whichever approach is used, it is important to eliminate unusual income or expenses, adjust the owner’s salary to a reasonable amount and determine a “normalized profit” or “maintainable earnings” with which to work.
For a proprietorship or partnership (i.e., a business that is not incorporated), owners do not receive a wage. Therefore, you need to reduce the business profits by a reasonable wage before applying your earnings multiple to the profits. What is a reasonable wage? One consideration is looking at how much you would need to pay in wages for someone to replace the owner. If a tradesman is operating a small proprietorship earning $30,000 per year where they are working 50 hours a week, that business does not likely have any value…the owner is not even receiving minimum wage. Why would you buy a business when you could earn just as much or more by working for someone else, or when you could start your own business and make just as much money? Sometimes there may be a reason, but think it through carefully. Sometimes, a business may have just launched a new invention that has a high potential of making a lot of money. In this case, perhaps the potential future profits make it a valuable business, and the past earnings are irrelevant. However, the risk is high and so this needs to be considered.
In conclusion, if the business is expected to have consistent earnings, the maintainable earnings approach is used. A multiplier is applied to this profit figure to reach a value. At a risk-adjusted interest rate of 20%, the multiplier would be 5.
Discounted Cash Flow
What if earnings are expected to fluctuate from year to year? Assume the company will have a profit of $10,000 next year, $20,000 the year after, and $30,000 every year after that. In this case, you do not have one figure to which to apply your multiplier. For years 1 and 2, separate calculations are required. In such cases, present value tables are used and the value of the future profit in converted to its value in today’s dollars. If an interest rate of 20% is appropriate, the profit of $10,000 next year is worth $8,333 today. Why? Because $8,333 invested today at 20% will be worth $10,000 in one year’s time. The profit of $20,000 in year 2 is worth $13,889 today because $13,889 invested today at 20% will be worth $20,000 at the end of year 2 ($13,889 x 1.20 x1.20).
What about the profit of $30,000 in year 3 and every year thereafter? A combination of both approaches must be used. At 20%, a multiplier of 5 is applied to the $30,000 in year 3. In other words, the value of maintainable earnings of $30,000 in year 3 is worth $150,000. Since this is the value in year 3, we must present value (or discount) this amount to today. $150,000 in year 3 is worth $86,806 today at a 20% rate.
The value of this company would be the sum of all three figures, totalling $109,028. Of course, do not forget to deduct the interest on any loans you need to borrow to buy the business.
If future cash flow can be reasonably determined, then use of the discounted cash flow method may be appropriate.
Other Considerations
There are many other issues to consider. Just a few are mentioned here.
Are you buying a business? If so, are you buying a fully operational business, or just a selected portion? Are you buying shares of the corporation, or the assets from within the corporation? (The pricing and tax implications are substantially different.) How will future profits be affected by your choice of financing?
Many industries have rules of thumb for reaching a quick valuation. However, these should always be verified with other more thorough methods. In addition, some businesses may comprise only assets that are best valued by way of an appraisal, such as a real estate or investment holding company. Then there are other businesses that may have a combination of assets requiring more than one approach.
It can get very complicated. That is why you should work with qualified professionals.
Blair Corkum, CPA, CA, R.F.P., CFP, CFDS, CLU, CHS holds his Chartered Professional Accountant, Chartered Accountant, Registered Financial Planner, Chartered Financial Divorce Specialist as well as several other financial planning related designations. Blair offers hourly based fee-only personal financial planning, holds no investment or insurance licenses, and receives no commissions or referral fees. This publication should not be construed as legal or investment advice. It is neither a definitive analysis of the law nor a substitute for professional advice which you should obtain before acting on information in this article. Information may change as a result of legislation or regulations issued after this article was written.©Blair Corkum