How helpful are discounted cash flow and cost of capital analyses when you’re analysing a small, unlisted enterprise?
Luke Morris, corporate finance partner at ScruttonBland, says that the income approach has the potential to simplify valuation theory for SME clients. Speaking at the recent ICAEW 2021 Business Valuation Conference, Morris stated that, “from a practical point of view, we help clients to make sure that return on investment is higher than cost of capital. If we get that right, we are winning.”
“The income approach differs from market approaches, wherein the analyst compares the business to similar assets where trading information is available,” Morris continued. Market data—from listed companies, for instance—may seem remotely connected to a small-business owner’s interests. In some cases, they may better understand how their discounted cash flows generate value.
First, the income approach basics as they apply to business valuation: The income approach converts future cash flow into a single current number by means of some sort of model. If that income stream is level, then we know that the time value of money can be calculated with a fixed annuity analysis.
Using annuity theory to create a capitalisation rate, valuers can extend current value into perpetuity. (DCF theory becomes more complicated when necessary growth and taxation factors are included, of course.)
Furthermore, as all analysts understand, “businesses are rarely stable … so we give our thanks for Excel spreadsheets,” says Morris. He argues that the concept behind the income approach is still relatively simple, despite these complicating factors. “The purpose of the analysis is to identify the value of all future cash flows discounted back to today. In the models, logically, lower growth creates lower value, as does volatility and lack of profits,” Morris explained. Again, nearly every small-business owner understands these concepts.
How do capitalisation and discount rates appear in practice for smaller businesses? Andrew Stickland (ScruttonBland and also a board member of International Institute of Business Valuers) looked at the practical application of these basic valuation principals, particularly in contentious situations where the tribunals look to financial experts for guidance. He noted two interesting cases where the income approach helped the tribunals reach a decision. One case depended on support the valuer provided for the reasonableness of a 2% growth rate assumption (N Green v HMRC (Chartersea) (2015)).
A second shareholder dispute case (Pinfold v Ansell (2017)) required the application of a DCF that settled with discount rates in the 19%-to-20% range. This case also assumed background economic growth only.
P/E ratios (from market approaches) do not “account for differences in capital structure,” which can be particularly problematic when valuers consider small enterprises. “A company should not be valued differently just by reference to the way that it is funded,” Strickland reminded ICAEW attendees.
Yet, if two companies have the same operating margins but one has high interest expenses, given the same P/E ratio, different values will be derived. “The highly geared company be penalised by P/E ratios valuations,” Strickland says.
Small enterprises create unique challenges for business valuation: BVWire—UK notes that RICS, IVSC, and other international valuation standards tend to assume debt, liquidity, and tax standards that are more typical of larger listed entities, so Morris and Strickland offered a few valuation essentials for small enterprises:
- EBIT multiple analyses will yield much fairer “enterprise value” results when small companies are financed primarily by debt;
- Post-tax analyses are essential to weight small-company cost of capital decisions that capture the impact of risk created by significant debt funding; and
- Increased diversification reduces risk. Since less diversified buyers tend to acquire small companies, the cost of capital of the presumed pool of potential buyers should support a lower value.