The Price is Right: Valuing Trading Companies
At PD Tax Consultants we value companies for all kinds of reasons, ranging from setting up employee share schemes to facilitating a management buy-out. In this article, we have provided a brief overview of the methods we typically use to value unquoted trading companies.
It is important to understand that valuing companies is both a science and an art, and each valuer will make different judgement calls resulting in a differing result. With this in mind, it is often appropriate to use two or more valuation methods in order to ascertain a better idea of a value range and to ensure that the valuation reached is reasonable.
1. Maintainable Earnings Method
The first and most commonly used method for valuing trading companies is the maintainable earnings method. The premise of this method is that the value of a company’s shares comes down to its potential to generate profits in the future, to be realised either via dividends or on a sale.
The Earnings Method involves determining a company’s future maintainable earnings, and then applying an earnings multiple in order to reach the company’s value.
When establishing a figure for maintainable earnings, the starting position is to look at the company’s historical figures. That said, it is important to bear in mind that we are valuing future earnings, so it is imperative that forecasts, the general economic background, the state of the industry the business operates in, and any upcoming lucrative contracts are all taken into consideration. Furthermore, it is necessary to make adjustments to reflect exceptional and non-commercial expenses, and/or income, e.g. directors’ remuneration, interest-free loans from directors, and use of assets which are owned by directors.
Once the future maintainable earnings has been established, an earnings multiple must be applied in order to reach the value of the shares. This multiple is determined by referring to the sale values of companies in the same field to identify what the market is willing to pay for the company’s earnings (with an appropriate discount applied).
2. Assets Method
The Assets Method of valuation works on the premise that the value of the shareholding can be realised either through a sale or a liquidation, and values a company based on the value of its assets (including goodwill) less any liabilities. This is therefore the most appropriate method where the company is on the brink of being wound up, or where the value of the net assets outstrip its earning potential.
3. Dividend Method
The premise of the Dividend Method is that one of the main objectives for a shareholder with a minority interest is to obtain income via dividends. Whilst it is theoretically appropriate for minority holdings to be valued this way, small private companies often have an unpredictable dividend yield and no formal dividend policy. Therefore, the dividend basis is rarely used in practice at our firm.
4. Hybrid Method
A Hybrid Method is sometimes a more appropriate way to value shares where a trading company also holds investment assets/assets surplus to the trade.
Voting Power & Discounts
Votes are the means of unlocking a company’s income and/or assets through decisions taken at general meetings, for example by declaring dividends or winding up the company.
With this in mind, a share held by a 50%+ shareholder is worth more than a share held by a small minority shareholder.
It therefore follows that discounts are applied to account for the difference in voting power a shareholding carries. The amount of the discount doesn’t just depend on the % shareholding being valued though; it is also important to take into consideration how the remaining shares are held. Even if the shares being valued represent a minority shareholding, they may nevertheless hold the balance of power and therefore command a lower discount.
What about COVID-19?
As a result of COVID-19, many businesses were forced to close their doors and there is significant uncertainty regarding when/if businesses will return to their pre-COVID profit levels.
With this in mind, when considering maintainable earnings it is crucial that the historical figures are not solely relied upon, and that consideration is also made to forecasts, business recovery plans, and whether the pandemic has demonstrated resilience or vulnerability in the sector.
Furthermore, whilst the earnings multiples for listed companies will reflect the impact of COVID-19, listed companies are often more diverse and better equipped to weather these difficult economic times. With this in mind, a greater discount to the earnings multiple may therefore be appropriate for smaller, less robust businesses.
Valuations cannot be boiled down to a simple formula. It requires knowledge and analysis of the business being valued, the conditions in the market, the abilities of senior management, and an understanding of the broader economic background in order to arrive at a reasonable valuation of a shareholding. It is therefore recommended that valuations are undertaken by those with the relevant knowledge and experience.