Valuing a business in 2024
Due to the up and down nature of the economy in recent years, it’s probably never been more difficult, but also never a more interesting time to value businesses. Analysing and assessing what’s the historical normal, what are the underlying company earnings, and what is going to happen in the future, is often a real challenge.
The standard formula applicable to the vast majority of valuations is:
Normalised Profit x Multiple = Enterprise Value
Enterprise Value + Surplus Assets – Debt = Equity Value
Normalised profit is profit that you could hope to achieve in a normal year, which excludes any exceptional items. Any non-market transactions – for example if somebody takes dividends instead of salary, meaning their profit and loss account might look healthier than it actually is – would be ‘normalised’ to try and arrive at the actual underlying profit.
Talking in general terms for hypothetical valuations, it’s usual to put some kind of weighting on normalised profits. A weighting of 3:2:1 is seen as the standard formula for most valuations, with 3 being placed on the most recent year (assumed to be the best example of future profits).
What’s happened now is that results are a bit choppier, and it takes a bit more finesse when putting together weightings and looking at what kind of figure you’d use. If you blindly stuck to the 3:2:1 formula, accepting the ‘Covid years’ as a washout where there was no profit, then you can come down to a weighted figure far lower than more current results.
There’s a lot more fluidity now in what kind of weighting you use, and in corporate finance transactions it’s almost as if it’s accepted that the previous few years really aren’t such a good sign, and it’s all about what you’re delivering now and going forward.
You then take the normalised profit and multiply that by the multiple, which is effectively the number of years an investor will wait to receive payback of their investment. A multiple is really a function of risk. If the business has traded or is expected to trade inconsistently a buyer may want their money back quicker, and therefore is going to pay a lower multiple. However, if it’s a business that has performed consistently, and has been around for a long time, then this could be an indicator that the risk is lower and therefore potentially a higher multiple is applied.
So, multiplying your normalised profit by your multiple gets you to your enterprise value – being the value that you could compare to other businesses in the same industry. To really value the business however, we need to take it a step further than that.
Firstly, you add on your surplus assets, being assets which aren’t used to generate profit for the business. A usual one of these is surplus cash: someone could have a couple of million pounds sitting in a deposit account that isn’t used within the business, so it’s fair to add it on to the valuation.
The same goes for creditors that aren’t part of working capital, such as bank loans and HP agreements – things that aren’t part of the working capital cycle and are typically amounts owed to third-party lenders. These would be taken off as debt.
During and just after Covid, we found that the pandemic had a triple impact on valuations. It hit revenues and therefore profits. Multiples reduced as perceived risk of investment increased. And equity adjustments were also hit, because businesses had burnt through cash and/or increased their level of debt to help keep the business running. For many businesses we have seen this trend reverse in the past couple of years as profits have picked up, deemed general economic risk has decreased, and debt has been repaid and cash reserves have increased. That being said, each business has been affected differently in the last couple of years.
If you would like to speak to the Ensors team regarding a business valuation please do get in touch.