Valuing a business can be a pretty complex process that can encompass one more of several methodologies, including Net Tangible Assets, Capitalised Future Maintainable Earnings (CFME), Discounted Cash Flow (DCF), or the Net Tangible Assets (NTA), amongst others. In certain industries, such as real estate and accounting practices, a shorthand valuation method known as the Industry Rule of Thumb has emerged over time that is often used as a ‘short hand’ method of estimating value. However, the most commonly employed valuation methods in small to medium businesses are NTA and the CFME.

The CFME approach involves assigning a value to a business by estimating the potential Future Maintainable Earnings (FME) of the business, which is then capitalised at a suitable rate that considers the various risk factors that the business faces, such as business outlook, investor expectations, growth prospects, industry volatility, and general economic conditions, and other unique entity-specific elements. The FME approach heavily relies on the effective ‘normalisation’ of the business profit and loss statements to reflect how the business has been performing once non-business and extraordinary income and expenses are stripped away, as well as the availability and analysis of comparable market data.

As the most widely utilised valuation technique, the FME method proves particularly effective for businesses with consistent performance and growth histories allowing for predictable forecast outcomes, regular capital expenditure requirements, and indefinite lifespans.

The earnings used as the basis of the valuation can net profit after tax or, more commonly, alternative metrics such as Earnings Before Interest and Tax (EBIT) or Earnings Before Interest Tax Amortisation and Depreciation (EBITDA). EBIT multiples can span a wide range, from 0.5 times to over 5 times earnings, depending on the industry, performance, and relative risk associated with the business.

The value derived from the product of the FME and the multiple applied provides the value of the business inclusive of all business assets, including plant & equipment, business vehicles, fit outs, and stock. It does not simply provide the value of the goodwill. The value of goodwill is what is left once you take the value of all business assets from the business value that you have just calculated.

The NTA method finds its relevance in scenarios where a business lacks goodwill or where the majority of its assets comprise cash or passive investments. Essentially, the business ought to be valued either by the CFME or DCF methods, with the resulting value reflecting a value that is equal to or lower than the realisable value of all of the business assets. This is how we diagnose that a business does not possess goodwill. Sometimes, this is particularly easy. For instance, where a business has been making losses (after you’ve normalised its profit), you will know that its capitalised value will also be negative and therefore it is unnecessary to go any further with your CFME calculation before moving instead to the NTA.

In this approach, the value of all assets required by the business in order to continue trading should be assessed at their realisable market value (in the case of a valuation of the business). In the case of valuing an entity such as a trust or company, the value of all assets and liabilities of the entity are appraised at their market value, and the resulting combined market value (net of any debt) serves as the foundation for the entity’s valuation.

The choice of valuation method hinges critically on the economic conditions and the specific nature of the company in question. During robust economic growth, I often lean towards the DCF method for businesses with high growth potential. This method projects future cash flows and discounts them back to their present value, accounting for the time value of money and associated risks. It’s a powerful tool, especially in industries like tech or renewable energy, where future cash flows can skyrocket. The DCF methodology is slightly more complex than its two cousins but is considered to be a superior method amongst most valuers. However, it too is fraught with peril, perhaps even more so than other methods, as adopting the wrong assumptions can result in a diabolically incorrect valuation. A DCF valuation relies entirely upon a cashflow forecast for the business that adopts reasonable and reliable assumptions about the expected income, expenses, incoming capital, and capital expenses over a period of (generally) three years. Like the CFME methodology, the value derived by the DCF method indicates the value of all business assets, not just the goodwill.

A common trap (other than assuming that the valuation is only considering the goodwill, have I mentioned that?) is an over-reliance on historical financials without adequate consideration of events in the past that may distort the numbers; think COVID, or perhaps a huge contract that was a one-off. Similarly, failing to adjust for industry-specific risks or not applying the correct valuation multiples based on current industry norms can skew the valuation, leading to potentially costly misjudgements.

This short article glosses over a huge amount of valuation theory, but hopefully provides a succinct understanding of the primary methods applied in valuing small to medium businesses and knowing the main elements in each. Keep an eye out for future articles that seek to provide a more complete picture, piece by piece…