Business valuations are subjective and are carried out on a hypothetical basis of a willing buyer and a willing seller.
The main methods used in business valuations are:
Dividend yield basis
Discounted cash flow
Main method for SME valuations
The method used depends on the nature of the company. For the majority of profitable trading companies this will be the earnings method. This technique calculates an adjusted normalised level for the earnings of the company and multiplies this by a capitalisation factor to arrive at the enterprise value of the company.
A capitalisation factor is the reflection of how long a potential buyer is willing to wait before they receive the payback of their initial investment. Clearly if investor confidence is lower, the level of risk is perceived to be higher. This will result in the potential purchaser seeking to pay a lower capitalisation factor to proceed with the deal.
Changes since the referendum
It is too early for any potential changes to affect the earnings in this method, as they are historical figures. Therefore any adjustment will be made through the capitalisation factor, as risk adverse investors will want to pay a lower multiple for the business for it to become an attractive proposition.
In the run up to the referendum it seemed that Owner Managed Business’ (OMB) investors became more cautious about expansion and were requesting initial valuation advice more often than we had seen in the previous year. This may carry on in a similar vein for the coming year.
Investor confidence will undoubtedly be driven by any effects on their own day to day business, which at SME level will ripple down from the confidence levels further up the chain. The private equity houses and property funds which we speak to, have informed us that it is ‘business as usual’ for company and property acquisitions, respectively.
Overall market confidence on the surface appears to have recovered, with the FTSE100 now 6% higher than on 23 June (pre-referendum). Many market commentators have noted that this index is not a good barometer as approximately 70% of its income is derived from overseas, which is why it only took until 29 June to rebound above pre Brexit levels. However the FTSE250 also drew level with its pre-referendum level on 5 August and as at 1 September has climbed 4% higher than 23 June.
Digging a little deeper shows a different story. The value of gold leapt 25% in the period 23 June to 7 July before gradually falling 7% over the period to 1 September. This is significant as the value of commodities rise when investor caution grows, as these are perceived to be less risky investments. Gilts are another favourite in a choppy economy; these too have increased in popularity to the point where negative yields were offered for some 3 year bonds in early August.
The increases in the FTSE250 could be a bubble or alternatively it could be buoyed by the decreased value of sterling encouraging inward investment which will ripple into the commodity and bond prices in due course. At this stage nobody knows for certain whether confidence will increase or decrease in the coming months and years.
The implications of Brexit have not yet caused any sizeable differences to the level of capitalisation factor which we are seeing applied to business valuations. This is in part driven by the private equity houses declaring that it is ‘business as usual’. Other than decreased confidence amongst smaller investors, which may be temporary, we are unlikely to see drastic changes to business valuation methodology until the terms of Brexit are agreed. Even then it might still be ‘business as usual’.
Our advice to those planning to sell part or all of their business is to start planning early and seek professional advice on the value of your business and how to “groom” it for sale. Key to those seeking to invest in SMEs is to undertake robust due diligence including stress testing the future financial projections.