I have been selling private businesses for more than 25 years in the UK, Australia and South Africa, and have found that nine times out of ten it is the multiple of earnings method that can best be used to give the quickest and most useful approximation for the vast majority of businesses.
Clearly, if your business is loss-making or its value relates almost entirely, say, to the ownership of a property or other asset rather than from profits derived from trading, then other methods could be more appropriate.
But if your business displays the following characteristics, and you are prepared to sell a majority stake for an up-front payment (i.e. without deferred consideration), then it should be possible to provide a rough indication of value using the multiple of earnings valuation methodology.
It requires the following:
- Your business has been trading profitably for three or more years.
- It has been making ‘normalised’ profits broadly within the ‘standard range’ for your industry.
- Your business is forecast to carry on trading in broadly the same manner, and with the same level of profitability.
So how does this work?
This rule of thumb is not as straightforward as people think. As the valuation name implies, there are two elements to the methodology, and both must be assessed correctly to give the most accurate ball-park figure. But this shouldn’t take too long.
The easiest way to determine the earnings to which the multiple must be applied is simply to take the most recent after-tax profits from your audited accounts. But if you do this alone, you could be leaving serious value on the table, and you may be able to make a case for a far better number.
Factors to consider are:
1. Where you are in your financial year
If you have a February year-end, and it is already November — you could make a case for more weight to be given to the current financial year (especially if you can support your forecasts with hard evidence) than the previous one.
2. Whether your profits have been ‘normalised’
There are often a number of expenses that, in the ordinary course of business, would not appear on your books. Perhaps you pay yourself way above market rates. Perhaps there was a once-off expense that won’t be repeated. Perhaps your spouse manages the switchboard but is paid as much as a director.
3. Your profit trend
If you have been growing steadily, but have now taken demonstrable steps to rapidly improve your rate of growth (through new products or by entering new markets), you can make a case that a buyer should give more weight to your future forecasts than your historical performance.
The key number to derive here is the future net maintainable earnings (FNME) of your business. This involves looking both backwards and forwards in time, and then applying a weighting to each year based on its relevance to the level of earnings you believe your current business could maintain.
Once you have determined your FNME, having taken consideration of the factors above, you need to come up with a multiple of profit after tax per year to apply to this.
In its simplest form, a private-company multiple is simply a discount to the average listed price earnings (PE) ratio for your sector. Discounts take account of such factors as the size of your business, its trading history, its level of diversification, the strength of its brand, the liquidity of the shares, etc.
A valuation practitioner will attempt to quantify the discount that should apply to each of these factors — but in reality private-company multiples tend to fall into a standard range.
This varies over time, but in South Africa over the past five years, and for businesses broadly in the R20 million to R250 million turnover band, this has tended to be in the five to seven range, as long as you have a relatively generic trading business.
How does this work in practice?
I recently did a ‘rule of thumb’ relative valuation of two media companies — both operating in the same industry, but with different characteristics in terms of years trading, size, location and profitability.
The smaller of the two companies, based in Cape Town, had been trading for six years, and although it had grown strongly to some R40 million in turnover, it had now reached a plateau as it struggled to grow to the next level.
The significantly larger company had been operating for more than 20 years, and although based in Johannesburg, also had significant revenue streams from overseas. Despite its size and maturity, it exhibited a lower profit before tax percentage than its smaller counterpart, and had a strong reliance on one or two large customers.
With the trading histories of both companies available from the audited accounts, and fairly detailed three-year forecasts with supporting assumptions readily to hand, I was able to derive an FNME for each company by applying weightings to each of the past three and forthcoming three years’ performance.
My starting point was to examine each year’s numbers, and then allocate a weighting as to how representative these were to how they might trade going forward.
Determining the multiple
The next step was to determine the multiple. A review of the listed sector in South Africa, and information on recent transactions in the media space confirmed that we were almost certainly talking in the usual five to seven range for privately-held trading companies. It was then a matter of applying differing discounts to the listed average PE for such factors as size, profitability, diversity, markets served, etc.
As expected, the larger of the two companies, despite its short-comings in terms of net margin and customer reliance, came out slightly on top. Both its relative position and years trading in the market, as well as the strength of its brand, gave it the edge.
With my rule-of-thumb analysis complete, I was able to offer a relatively narrow range of values for each company, which came out within a few percent of each of the owners’ expectations of their own, and their counterpart’s, relative value.
Although not necessarily carrying the weight of a detailed and ‘signed-off’ valuation report, this quick rule of thumb can be every bit as accurate as the more expensive and comprehensive methodologies most valuation practitioners employ. But as a swift and relatively accurate approximation, it can certainly meet the needs of many business owners.
Putting it all together
At its most simple, taking your most recent audited profit after tax and applying, say, a multiple of six will give you an immediate ball-park number for your value. But this may not be your best rule of thumb!
Apply a little more time and thought, derive an FNME that you can defend, and you can find that the value you are placing on your business could in fact be substantially higher — especially if you are growing strongly and perhaps improving margins.
Lastly, recognising such factors as your level of diversification of products and customers, the strength of your brand and the relative size of your business relative to your competitors, to name but a few, could allow you to make a case for a higher multiple — nearer to 6,5 or even 7.
So instead of, say, R10 million x 6 = R60 million – with just a little work your rule of thumb could be justifying, say, R12 million x 7 = R84 million — which is 40% higher — and definitely worth the relatively small extra effort.
Methods of valuating a business:
- An asset-based valuation plus an assessment of goodwill
- A discounted cash-flow valuation
- An industry specific ‘norm’
- A multiple of earnings valuation.
What To Measure To Make Sure Your Business Won’t Crash And Burn
Let your customers measure success for you and you’ll have a better idea of how to reach your goals.
If you don’t want your business’s spurts of success to end up just a flash in the pan, you need to measure your business progress against your goals. This allows you to adjust your plans for future success accordingly. But how?
Back in the nineties, NASA designed an interplanetary weather satellite to orbit Mars. However, it deviated from its planned trajectory and was destroyed in the atmosphere, simply because of a minor miscalculation; a result of the NASA team and their contractor using different systems of measurement.
By the same token, business owners need to determine what metrics to use to measure their progress, before they can work out what still needs to be adjusted to get them to their ultimate goals. Many businesses know this, but many don’t know they’re doing it wrong.
Connect with your customers
Most organisations use the same key performance indicators such as sales, customer retention, and product quality to track their progress. What’s the problem with this picture? They’re measuring where they are now in relation to where they were before, leaving the question of where they want to be, and how to close the gap, to guesswork.
Why waste time testing one strategy after another when you can find all your answers in one place: With your current and prospective customers? They’ll tell you exactly where to aim and what to do to get there. This is why customer surveys are the proverbial toolkit of business progress tracking.
A customer survey is simply a series of questions that you ask your customers, to gauge their satisfaction, so you can hold on to them and collect ideas about how to improve your business offerings.
There are a number of ways to distribute these surveys, but it’s no surprise that social media is trumping phone calls, text messages and emails as the preferred platform for customers to communicate with businesses and brands.
Engage with your customers
What you choose to ask your customers is entirely dependent on what goals you wish to outline and track. That’s the easy part, but it’s significantly harder to gauge the effectiveness of social media campaigns, because you need to know what to look for. You can measure awareness of your business using metrics including volume, reach, exposure and amplification.
Retweets, comments and replies will tell you how engaging your content is, and you can keep an eye on traffic by tracking URL shares, clicks and conversions. Plus, there is a plethora of additional plug-ins to this from ORM and sentiment tracking tools for deeper analysis of this data.
Related: Does Your Customer Service Care?
The catch is that in the past, businesses had to compete for space — on billboards, in magazines, during ad breaks on TV — but now it’s all about timing. So the first challenge is making sure your social media post questions are being seen by as many of your customers as possible.
On the flip side of the coin, people don’t have to have any previous experience with your brand to interact with you on social media, so another challenge is calculating which of your respondents are actually viable customers.
Leverage your data
You’ll need to tap into the analytics that speak to who your followers are, and then focus on finding ways of channelling them on social media, based on their geographical location and the kind of content they are most likely to consume.
Then test your social media measurements against your key performance indicators. Yes, we’re back where we started, but this time you’ll be armed with what you need to leverage this data, in order to achieve your business goals.
How Do I Go About Valuing My Business?
Francois Otto, Head of Corporate Finance and Jonathan Wernick, Corporate Finance Transactor, Sasfin Capital give advice on how to value a business.
Francois Otto, Head of Corporate Finance and Jonathan Wernick, Corporate Finance Transactor, Sasfin Capital give advice on how to value a business.
If you have ever thought about raising capital for, or selling, your business? Perhaps one of the most difficult questions you have had to ask yourself is “How much can I sell my business for?” Regardless of what anyone tells you, determining the value of your business is a subjective process.
The value of business in one person’s hands can be completely different to another. However, there are a variety of methods to determine the value of a business. Some methods are fairly simple and others are a bit more complex.
Perhaps the simplest method that can used to value your business is to determine its Net Asset Value (“NAV”). This simple method entails subtracting the value of the liabilities from the value of the assets.
Another method that can be used to value a business is to apply a specific multiple to a financial metric. This method is referred to as a comparative valuation or “MULTIPLES” approach. For example, a company’s net profit could be multiplied by a specific number to give you a value of the business.
The number which you multiply the earnings by is referred to as a “Price Earnings” or “PE” multiple. The size of this number will depend on the business in question, for example its growth prospects, its size and the industry in which it operates, just to name a few.
The final approach that can be used to value a business is the discounted cash flow (“DCF”) method. This method adopts the philosophy of “Cash is King”.
Under this method, the business is valued using cash flows that the business is expected to generate. Cash flows can take the form of future dividend payments or, if the business pays a small or even no dividend, cash flows can take the form of profits generated by the business after adjusting for future capex, investments in working capital and taxes payable.
As this method values a business using the cash flows it is expected to generate in the future, a discount needs to be applied to these future cash flows (to reflect the uncertainty thereof), the size of which increases the further out in the future the cash flow occurs. The aggregate value or sum of these discounted cash flows represents the estimated value of the business.
Related: Here’s How To Value Your Business
The three valuation methods (NAV, MULTIPLES or DCF) mentioned above can yield different values for a business and deciding which method to use will often depend on the purpose of the valuation as well as the specific business being valued.
This exercise is normally the first step in raising capital or selling your business, to provide the owners with a sense of value. This value is theoretical until such time as a willing investor agrees to a transaction.
This is where a good adviser will assist the owners, through effectively marketing their business, to optimise the value achieved by the owners with the added benefit of ensuring the terms of a transaction are fair to the owners (e.g. reasonable earn-out conditions and warranties).
How You Can Use Your Creditors To Fund Your Business Growth
Everything you need to know to keep your cash flow positive, use your creditors to fund your business, and make your numbers work for you.
The success of a business is often judged by its rate of growth and its number of employees. The problem is that both a business’s rate of growth and its size come with their own demands and consequences, which are often ignored in the pursuit of more and more growth.
The reality is that not all growth is created equal. If your business doesn’t have scale, you can end up growing yourself into trouble — or even out of business.
Even more important is positive cash flow. Is that great new contract bringing in money, or costing you money? Shouldering an upfront cost for growth down the line is all part of the growth journey, but only if the numbers make sense and you know when your investment will turn to profit.
Here’s the secret to growth: It can be self-funded. Yes, there are venture capitalists, private equity firms, angel investors, bank funding and a host of other ways to access finance — but you can grow a large, successful organisation without any of these.
The trick is to know your numbers. Here’s how you can practically apply the rules of positive cash flow to your business.
The Power of Cash
In 2012, Amazon’s share price was $173. By 2016 this had grown to $725. Walmart, arguably the biggest retailer in the world, went from $59 to $70 in the same period.
But take a look at Table 1 for the revenue growth of both companies between 2003 and 2012 (a trend that has continued).
How can Walmart’s stock price have hardly increased, while Amazon experienced impressive growth over the same period, despite the fact that Walmart’s revenue growth far outstrips Amazon’s (in absolute, not percentage terms)? Is Walmart’s stock undervalued, and Amazon’s overvalued? Even accounting for growth off a low base, how can we explain this?
The share price is simply the net present value of future free cash flows generated from the efficiency of an organisation in managing cash to generate more sales.
In other words, Jeff Bezos’ focus on his cash conversion cycle has meant his business is incredibly cash-positive, which has in turn positively impacted Amazon’s stock price. Although Amazon is a highly unusual business with its negative cash conversion cycle, and its actual liquidity is somewhat contested by the investment community, it’s a great example of getting customers to fund growth.
The Cash Conversion Cycle
We agree that it takes money to make money. A business, even one with a tight, scalable business model, will consume more cash in its growth phase than in its steady state, or execution phase.
But, you don’t want to ever spend more money than you need to — or can reasonably afford to. This is true whether you’re self-funded or spending someone else’s cash, but particularly if you’re funding your own growth. Dealing with unplanned funding can be costly, time-consuming and it hampers growth. It also bogs you down in stressful admin when you could be focused on the elements you love and that excite you.
There are two questions that you should have asked yourself as you embarked on your growth journey (note: if you’ve never asked these questions, you need to surround yourself with like-minded business people who can help you find and ask them):
- For what period of time is my money tied up in inventory and other current assets before customers pay for the end product or services?
- How much cash do I need to finance each unit of sale and what is the amount of cash generated by each unit of sale?
I guarantee you that Jeff Bezos knows the answers to these two questions. Not his accountant or financial director — Jeff himself. You can’t abdicate the numbers of your business to someone else. Understand the difference between delegation and abdication. You don’t need to be doing your business numbers but you absolutely need to know what they are. This is one of the most important metrics of your business.
Let’s go back to our example of Amazon (see Table 2): Bezos’ cash conversion cycle (measured in days), oscillates between -40 and -8 days. That’s the secret.
In other words, Amazon uses other people’s money to fund its operations. That’s an extremely valuable business model, as its share price demonstrates.
Walmart’s cash conversion cycle is also a very respectable 11 days. As a business model it’s not quite as valuable as Amazon’s, but there’s a reason why Walmart is an international leader in its industry. It takes this behemoth organisation just 11 days to convert $1 into something worth more than $1. It then recycles that original $1 a further 35 times per year. Walmart’s margins are not high, but the compound growth is very powerful, as we’ll see later.
Let’s Get Started
Step 1: Understand your business
To better understand the components of your operating cash cycle and your cash conversion cycle, take a look at Diagram 1.
Operating cash cycle (OCC) is the period of time between when you start the assembly of all the required inputs into your production line, and cash comes back into the business as payment for the sale. Remember, if you’re a B2B business, there’ll be a delay between when the customer starts using your product and service, and when payment is made as well. This difference is referred to as accounts receivable days. Likewise the time between when your production starts (having received inventory) and the moment your business pays for this inventory, is the accounts payable days.
Cash conversion cycle (CCC) This is the period of time that working capital is tied up. It’s the time between when cash was converted into one of the inputs for your production line, and when the product is converted back into tangible cash, handed to you when customers pay you in real money. It’s the difference in time between your operating cash cycle and account payable days.
Self-financing growth rate (SFG)
This is the crux of this article. Your SFG rate is the rate at which growth can be sustained by cash generated by your business without any external funding.
Step 2: Working out your cash conversion cycle
Where can you access the figures you need to determine your own OCC, CCC and SFG? First, use data spanning a 12-month time period. This has two advantages: You have a better chance of sourcing accurate data if it comes from a signed off financial statement, and you can dampen the noise caused by seasonality.
Work with your balance sheet and income statement.
Working out conversion days from balance sheet
|Asset||ZAR amount on (000)||Equivalent days||Liabilities||ZAR amount on (000)||Equivalent days|
|Cash||10||Accounts payable||99||Calc A|
|Accounts receivable||384||Cal B||Loan
|Inventory||263||Calc C||Current liabilities||149|
|Current assets||657||Retained earnings||183
|Plant & equipment||25||Capital contributed||350|
|Total assets||682||Total liabilities||682|
Working out conversion days from income statement
|IS line||ZAR amount on (000)||Day equivalent||Ratio|
|Line||ZAR amount on (000)||Day equivalent in (000)||Ratios in %|
|Revenue / Income||2 000||= 2 000/365 = 5 479||100|
|Cost of sales||1 200||= 1 200/365 = 3 288||60|
|Operating expenses||700||= 700/365 = 1 918||35|
|NPBT – net profit before tax||100||5|
Based on the above example and figures, we have determined the following information:
- This business generates R5 479 of income per day at a cost of R3 288 per day.
- Calculation A: We owe a total of R99 000 to our suppliers, which at
R3 288 per day is ~ 30 days from
99 000 / 3 288
- Calculation B: We are owed R384 000 from our customers, which at
R5 479 per day is ~70 days from 384 000 / 5 479
- Calculation C: The amount of inventory we have paid for and need to turn into a sold product in equivalent days is ~ 80 days from 263 000 / 3 288.
Our original ‘as-is’ timing diagram now looks like this:
We still need to account for operating expenses, including salaries, utilities, rent, marketing costs and so on, and we can safely assume (but check this for your business) that bills arrive uniformly over the 150 day OCC period, meaning some will be paid immediately (day 1) or have to wait (day 150). On average this is 75 days.
You should now interpret the information as follows;
- The OCC is 150 days, but because the business has 30 days to pay its suppliers, the CCC is 120 days. In other words, cash is tied up for 120 out of 150 days (80% of the time).
- In terms of operating expenses, we assumed a uniform distribution over the period whereby some creditors would be paid immediately and some would have to wait for the 150-day cycle to finish. On average, this leaves us with 75 days or 50% of the OCC.
Related: Mobility, Security And Your Business
Step 3: Unlock capital in your business
We now know for how long our cash is tied up, but we still need to determine how much is tied up. Using the ratios in the original income statement, we can now answer the following: What amount of cash is needed to finance each unit of sale, and what is the amount of cash generated by each unit of sale?
Cash conversion at work on your IS
|Income statement line||Per ZAR||with CCC factoring||effective per ZAR|
|Cost of sales||0,60||80% (120/150)||0,48|
|Operating expense||0,35||50% (75/150)||0,18|
|Total costs||0,95||Cash tied up per 1 ZAR of Sales Revenue||0,66|
|Profit before tax||0,05|
|Free cash generated per ZAR of Sales||0,05||Cash needed for each OCC||0,66|
Putting it all together
Let’s look at what you now know about your business:
Self-funded growth rate
|The cash generated from 1 ZAR of sales||By looking at the income statement ratio||0.05|
|The time in days of your OCC||Calculated from holdings inventory days + accounts rec days||80 + 70 w= 150|
|The CCC time to cycle cash used in the OCC||Calculated from OCC – accounts payable days||150 — 30 = 120|
|The cash tied up in each OCC for a 1 ZAR sales income||Restated IS with CCC factored in for OpEx and inventory||0,18 + 0,48 = 0,66|
|Your per cycle growth rate||Free cash that can be added to the OCC cash requirement||0,05 of 0,66 -7,57%|
|How many cycles can be completed in a year?||Days in year available divided by OCC||365/150 = 2,43|
|Assume a productivity factor for safety||90% as a reasonable contingency for strikes etc||2,43 x 0.9 = 2,19|
|Compounded annual self-funded growth rate||(1 + SFG) OCC cycles – 1) = (1 + 0,0757) 2.19 – 1 =||17,3%|
Driving growth in your business
So, how can you use this information to drive growth in your business?
First, your debtors book must exceed your creditors book. Then, if we just shorten our accounts receivable days from 70 to 30 days, the following would happen:
- The OCC is now 150 — 40 = 110 days
- CCC is 110 — 30 = 80 days
- Cash needed for cost of sales is 0,60 X 80/110 = 43 cents
- We have not targeted operating costs yet, which remain at 18 cents
- Round everything up and we now need 62 cents instead of 66 cents (6% improvement)
- Your per cycle growth rate is 5 cents/62 cents = 8% growth rate
- How many cycles can you do in a year now? 365/110 = 3,3 cycles; up from 2,43!
- This is a 36% improvement
- Add a contingency of 95%, which gives us 3,13 cycles
- Compound this over a year: (1+ SFG) nbr of cycles — 1) = (1 +0,08) 3,1 -1) = 26% from 17% originally.
That’s 9% growth and nobody noticed a thing!
- That large corporate account that you cherish and that one of your sales executives is overly proud of landing may well be destroying value in your business. Why? Because large corporate accounts tend to get over-serviced (and I doubt you allocate those costs properly) and tend to pay you late.
- Growing with a greater number of smaller customers, steadily over time, within your means and without being bullied delivers more value and less stress.
- There are easy and clever ways to add lots of value to your business, that cost very little to implement, but you do require an understanding of how cash gets tied up.
- Delegate, don’t abdicate. No entrepreneur is ever great at sales, production, operations and cash management, so get people who can complement your skill set, and allow you to do what you enjoy. That said, you can never hand the numbers over to someone else. Receive assistance if you need it, but know your numbers!
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