June 13, 2010
There's nothing simple about estimating the value of a business you want to acquire. Valuating a business is not a simple exercise, nor is it an exact science. It simply provides a theoretical value that will give you an idea of the fair price to pay for a business.
You mustn't rely only on the judgement of your accountant or of the seller. It is recommended that you have an expert, who specializes in business valuations, produce an independent report. While this is an unregulated field, the Canadian Institute of Chartered Business Valuators (CICBV) does provide guidelines and a code of ethics.
In general, you will rarely be able to compare your potential acquisition with a similar transaction. There is little information available on such transactions and they may not even apply to your specific conditions. Also, the terms may be too closely related to a particular sector to be useful.
3 degrees of assurance
According to the CICBV, there are three types of reports, they vary from the most general to the most detailed:
- Calculation report: provides an approximate valuation for initial planning.
- Estimate report: ideal for preliminary negotiations, succession planning, and situations involving important issues that are subject to budgetary constraints.
- Comprehensive report: appropriate in situations that involve high risks, important issues, or when there are legal proceedings.
To prepare their reports, evaluators look at the facts and financial data, formulate a conclusion, and the possible impacts on the estimated value. They will also add a disclaimer regarding the scope of the mandate, which varies with the quality of the report provided.
To produce a calculation report, the valuator reviews and analyzes the financial information and may meet with management.
The estimate report takes the same approach but is more exhaustive.
In the comprehensive report, the valuator provides an opinion. It is a more in depth analysis of the business and it reviews:
- Patents, bylaws, and shareholder agreements
- Business' economic situation and sector
- Market conditions and the competition
- Clientele and any contracts, backlog of orders
- Suppliers contracts and commitments
- Visit to the business
- Financial and forecast data
- Rationale for the choice of discount and capitalization rates using accepted financial models
Basic valuation principles
The first step in the process of establishing a price consists of determining the fair market value of the business. The three main valuation principles are:
- Value is dependent on expectations
- Value is dependent on future cash flows
- Value is dependent on tangible capital assets
There are two basic ways of determining the value of a business:
- Book value: company's net worth, which is equal to assets minus liabilities. What is shown in the financial statements.
- Liquidation value: assumes that the business sells all its assets, pays off all its debts, including taxes, and distributes the surplus to its shareholders.
- Earnings and Cash flow
- Discounted cash flow: value is based on the future cash flows of a business.
- Going concern value: assumes that the business will continue operating and compares the current cash flows with future inflows to make projections.
Some of the most common techniques used to calculate a business value include:
- Capitalization of typical net earnings: A value can be attributed to future earnings resulting from the acquisition. To obtain the going concern value, a capitalization multiple is applied to these earnings and non-operating assets are added.
- Capitalization of typical cash flows: The same as above with the exception that cash flows, rather than earnings, are capitalized.
- Discounting of expected future cash flows: Consists of determining the most likely future cash flows and discounting them at the valuation date.
- Determination of adjusted net assets: Liabilities are subtracted from the determined fair-market value of the assets. It is used for businesses, such as those in the real estate sector, whose value is asset-related rather than operations-related.
For more information, consult the Steps to Capital Growth guide included on Canada Business website.
In some sectors of the service industry the value of a business is based on a multiple of revenues. For example, an insurance brokerage firm can be worth 1 to 1.5 times the commissions received over a period determined by negotiation.
In the final analysis, purchase conditions and the final price paid will be determined in your negotiations with the vendor.