Determining enterprise value with rules of thumb & historical figures

Rules of thumb and historical figures are often used to calculate the value of a business. The major disadvantage of these methods is that they look mainly at the past and not at the future earning potential of a business. And for a buyer, that is in fact the only thing that matters.

In a business acquisition, both the seller and the buyer want to determine the value of the company in question. However, value is a subjective concept.

Waarde is often determined by personal perspective (an annual Ajax ticket is worth more to a soccer fan than to a basketball fan) and by circumstance (a glass of water is probably worth more to someone who has been walking around the desert for three days than to someone ordering an espresso on a terrace).

Waarde or price?

But first we want to point out the difference between the value of your business and the price of your business. Value is a (subjective) estimate of the possible price.

The fact that the seller usually has a higher value in mind than the buyer already indicates that these are perceptions and not objective truth. Your calculated value of your business is the starting point with which you enter negotiations.

The price is the amount the buyer will pay for your business. The price is the final result of negotiations and is influenced by several factors, such as the financial position of the seller, the degree of competition from other prospective buyers, the method of financing by the buyer, the tax consequences, the negotiating power of both parties and last but not least: emotion, how badly does the buyer want and how badly does the seller want?

Thus, Waarde and price are two different concepts.

To arrive at a somewhat objective valuation, many methods are used in practice to standardize a business valuation. These valuation methods mainly take historical (accounting) figures as a starting point. These figures come from the business's records and financial statements.

The advantage of this approach is that it quickly gives a first indication of the value of a business. The disadvantage is that the future of the business - and that is what the buyer is primarily interested in, after all - is hardly considered, if at all. These methods give correct results only by chance and leave future earnings completely out of the equation.

In practice, the following valuation methods based on historical (accounting) are widely used:

1. Rules of thumb
2. (Improved) profitability value
3. Intrinsic value

We discuss each method in more detail below:

1. Calculating enterprise value based on rules of thumb

In small and medium-sized business practice, the use of rules of thumb (also known as multiples ) is commonly used to determine the value of a business. These include formulas such as:

• 5 x net profit
• 0.75-1.5 x annual turnover
• 1 x net asset value + 2 x net profit
• 4 x EBITDA
• 5 x EBIT

This list can be infinitely supplemented with other values and other variables, such as an amount per regular customer or subscriber. Within an industry, a kind of consensus has often developed as to which rule of thumb applies to that market. For example, for the same revenue, an accounting firm is worth relatively more than a cleaning company. So rules of thumb do not represent a universally applicable "truth" that is applicable to all businesses or industries.

A rule of thumb provides guidance when valuing a business. If it is customary in an industry to use four or five times the net profit as a starting point, that gives a first indication of the value. Other things being equal, a value of five times earnings means that the buyer, due to its higher financing costs, will have to work for more than five years to recoup the acquisition.

And that doesn't take into account that payment is made "today" and profits will only be received in the coming years. So if the buyer wants to shorten the payback period, he will have to grow the business.

Disadvantages of rules of thumb

Rules of thumb are easy, but they also have drawbacks, especially from the buyer's perspective. We briefly mention the three biggest disadvantages:

• Discussion of the concept of net profit. Annual figures are usually normalized, often in the seller's favor, thus releasing the formula to polished figures.

• Rules of thumb are based on historical figures. Profit in the future is set equal to the average of recent years. But past profits are no guarantee for the future. Especially if the seller has been very decisive for the commercial success of the company, it remains to be seen whether the same profit will be achieved in the future.

• Rules of thumb ignore the specifics of a business. How dependent is the business on its owner? Is there a lot or little debt capital in the business? Are major investments needed in the short term?

The foregoing disadvantages mainly play for the buyer, but a rule of thumb can also be disadvantageous for a seller. This plays out especially with fast-growing businesses. In the past, profits were low because your business was in the start-up phase. But in the coming years, as the business gains steam, profits are expected to be much higher. A rule of thumb takes little or no account of this future scenario, and so the value picks up too low. in short, there are quite a few drawbacks to this method.

Calculate enterprise value based on profitability value 2.

With valuation according to the profitability value, you are already looking a bit more into the future. It is a simple way to determine the present value of the expected profit. This calculation involves two steps:

• First, you determine "normal" profits based on average, normalized past profits and expectations for the future.
• Then divide this profit by the required return on equity.

This yield requirement is often based on the interest rate on a long-term risk-free investment plus a surcharge for industry and entrepreneurial risk. The higher the yield requirement, the lower the value of the business.

Clearly, the interests of buyer and seller do not run parallel in this method. Discussions can also arise about the amount of "normal" profit used in the formula.

Improved profitability value

A variant of the normalized profitability value is the so-called "enhanced profitability value. This variant takes into account the buyer's desired financing ratio between equity and debt of the business to be valued. The higher the proportion of debt in a business - i.e., the higher the debt - the less it is worth.

3. Calculating enterprise value based on intrinsic value

The net asset value indicates the value of the company's equity: the total of its buildings, machinery, inventory, cash and cash equivalents and the like, less its debts. The book value of equity is the starting point, then the hidden reserves and deferred taxes are adjusted accordingly.

Intrinsic value is only a snapshot, which makes the method less suitable than other, dynamic methods. Intrinsic value cannot be determined entirely objectively, because the numbers can be affected in many ways.

The value of fixed assets is determined by depreciation periods, residual value and accounting policies. By "playing" with these variables, the intrinsic value of the company can be boosted. Reducing provisions (loan capital) also increases equity.

Suitable for poorly run businesses

Another disadvantage is that the intrinsic value only says something about the value of the assets, but not about the potential to make money with these resources and thus about goodwill. In a healthy, growing company, intrinsic value can be considered the minimum value of the company.

Determining the value of a business on the basis of its intrinsic value is therefore only useful for badly run businesses with continuity problems and in which there is no goodwill.