Building and measuring shareholder value: business valuation

Tony Granger describes a formula that might be considered for the purpose of measuring business value. 

Measuring business value is important when considering a business for sale, or to evaluate the impact of advisers and consultants on the business. 

It also goes a lot further than the more commonly accepted methods of valuation familiar to most – the net asset value (i.e. broadly assets less liabilities); the intrinsic value method (a hybrid of valuations including net assets plus the value of income streams, future spend values of clients); and the super profits method (any of the other methods, plus goodwill).

The seller will have a price in mind, the buyer a different price. The purchaser may only see net asset values; the seller sees the goodwill value of the customer base. The purchaser will wish to consider the true profitability of the business. Adding value to the business enables the seller to increase the sales price, and this is measured through increased profits or return on investment. Inherent in the business value equation is reducing costs and taxation. Profits could stay the same, but reduced costs and tax increases value.

The value of a business is sometimes expressed as a formula:

∑ (IP + RP) x [M] = AV + IAV

Where:

∑ = the sum of; IP = improved profit; RP = risk protection; M = free cashflow multiplier; AV = added value; IAV = intrinsic added value

Improved profit is the result of cost reduction and tax reduction, which is immediately added to the bottom line. Cost reduction audits and strategies can create savings. Tax reduction is usually through a spending process, such as pension contributions reducing taxable income. However, this spending is offset by the intrinsic added value element, which is increased. Increased pension fund values increase the value to employees, for example. Purchasing new equipment adds value to the business through increased productivity, increasing profits.

Risk protection adds value – without it the business could suffer loss, adversely affecting profits. An example is the loss of computer data affecting the business; or a fire or other catastrophe, or employee fraud. There is a cost for this in insurance premiums.

The free cash multiplier is a valuation method of similar companies in a business sector (divide the price by its cash flow) obtaining a price to cash flow multiple – similar to a price/earnings ratio. An example is a profitable, reasonably healthy, small business that will sell in the 2.0 to 6.0 times EBIT (earnings before interest and tax). If annual cash flow is £200,000 the selling price could be between £500,000 and £900,000 with a range of 2.5 to 4.5 multiplier range. 

Added value is the immediate and tangible value added as a result of your actions. 

Intrinsic added value is the immediate tangible and intangible value added as a result of your actions. It may not add value to the business but may benefit employees as well as the employer.

 

	IP	+RP	X M	= AV	+ IAV
Before action	£250,000 profits	0 – no risk protection in place	3 x industry average multiplier (profits)	= £750,000	+ 0
After action	£320,000 increase in profits after cost and tax reduction exercise, including increased pension contributions	£150,000 value of input risk protection after insurance and tribunal costs, health and safety cover and identifying risk areas	3.5 x industry average multiplier (profits)	+ £1,645,000	+ £30,000
Increase in business value				+ £895,000 (119% increase in value)	+ £30,000

The company reduced costs and tax, thus increasing profits by £70,000. A pension contribution of £30,000, deductible to the company, increases employee value. Company risk reduced. Value of risk protection set at £150,000. Company industry average multiplier was 3. Management and financial controls strengthened increasing it to 3.5x. The business did not increase sales to more than double its value – it became smarter.