Exclusive Q&A On Business Valuation With Heather Gray

1. When should a business conduct a valuation?
 
There are many reasons why businesses conduct valuations, most triggered by a specific event. 
 
The need for a valuation often arises when a company is at a critical juncture – it may be planning an acquisition or disposal, trying to resolve a shareholder or joint venture dispute, or seeking to reduce the gap between intrinsic and perceived market value. In these situations, it is critically important that management and shareholders fully understand the value of their business so that they can make optimal decisions and strengthen their position during negotiations.
 
Valuations may also be required for regulatory, legal or accounting reasons such as the requirement to value acquired intangible assets including brands and customer relationships when accounting for an acquisition under IFRS.
 
In most situations, a business will not be obligated to obtain an independent valuation from a third party valuer.  However, it may wish to do so simply to get an external perspective or in circumstances where there are conflicts of interest within a company in which case the board may seek an independent view for good corporate governance or to reduce the potential for dispute among its members.
 
What is rare in my experience is for businesses to conduct valuations outside of these trigger events. But I would argue that given that businesses are generally run with the aim of creating value, undertaking a valuation exercise provides useful insight to management. Going through the process of valuing a business increases management’s understanding of what it is in the business that really drives its value. Management are then able to focus its attention and resources on those important drivers.
 
2. What are the key factors affecting business value?
 
Every business is different and it is therefore important to take the time to understand what drives value in each case.
 
Ultimately value is about the future cash flows that a business is expected to generate and there are many factors which impact how the value of these future cash flows are assessed – For instance - What is the quality of the earnings?  What are the risks?  How much of the cash flows are underpinned by what the business has already achieved (e.g. contracts already won) versus what is ‘hope value’ to be achieved in the future?
 
Company specific factors which affect business value may include the level of capital expenditure and investment, demand for products or services, projected sales and costs, quality of the physical asset base (property, equipment etc.), quality of the intangible asset base (e.g. strength of brand, patents, product rights), availability of working capital, level of debt and quality of management and employees,
 
External factors will also affect business value including the state of the economy, access to finance and general business confidence. Specific inputs into valuations are also impacted by external factors such as interest rates and government gilt yields.
 
In the case of an acquisition or sale of a business, an additional consideration will be strategic value where there is value that certain purchasers can obtain from acquiring a business through synergies or other strategic benefits.
 
3. Can you discuss the main valuation methods?
 
I would always recommend using several valuation methods where possible to give a range of values which serve as a cross check to each other.
 
When valuing a business as a going concern, the typical valuation methods applied are Income and Market based approaches as follows:
 
 - Discounted Cash Flow approachwhich values a business based on the present value of the business’ expected future cash flows, discounted back at a rate that reflects the time value of money,  the  investor’s view of risk of the cash flows and the financing mix used to finance the business; and
 
 - Multiple of earnings approachwhich values a business by applying a multiple to earnings based on benchmarks from comparable quoted companies and comparable transactions.  . Earnings multiples typically applied are EBITDA, EBIT and revenue multiples to determine Enterprise Value and price earnings (PE) ratios for equity values.
 
Other methods  including cost based approaches and net assets based methods, are used less frequently for going concern business valuations although they may be more relevant as a valuation method for property and investment companies or when considering value on a break-up basis.  
 
Other methods when valuing minority interests would include a dividend yield based approach.
 
4. What new difficulties occur when conducting business valuation for cross-border M&A activity?
 
Difficulties can arise as a result of a lower level of understanding of the market the target/acquirer is operating in and other subtleties such as cultural differences and different market practices. It is imperative to consider country specific issues and risks such as political, economic, legislative, regulatory, reputational and tax risks as well as differences in accounting standards and access to reliable financial information.   As examples, expected GDP growth will impact cash flow forecasts and terminal value growth assumptions and inflation will also need to be properly adjusted for in the cash flows and / or discount rate.  The ability to repatriate earnings or dividends will also be an important consideration including factoring in with-holding tax.
 
5. How would you choose the best stock valuation method?
 
It would depend on the type of business and availability of information but typically I would use the Discounted Cash Flow (DCF) approach if cash flow forecasts are available.  This method applies an appropriate Weighted Average Cost of Capital to discount forecast cash flows to determine the Enterprise Value (EV) of the whole business. Eliminating the net debt (gross debt less cash and cash equivalent) and minority interests from the EV produces the Equity Value, which is typically how much an equity buyer would be willing to pay for the shares in the business.  I would typically cross check the results of the DCF valuation to values based on earnings multiples and if applicable other methods such as dividend yield.
 
6. How are disputes over valuation resolved when negotiation fails?
 
Typically the process governing the resolution of disputes over valuation relating to the transfer of shares is detailed in the Shareholders’ Agreement or Articles of Association of a company.  These legal documents may cover matters from the selection of an independent valuation expert and the basis of valuation to the steps to be taken after the independent valuer provides his/her opinion.  These documents are a key place to start when establishing the parameters for negotiating valuation in the context of a dispute.  For instance in the case of the valuation of a minority shareholding they may provide guidance as to whether a discount is to be applied to reflect the minority position or whether the valuation is to be done on a pro rata basis to the value of 100% of the shares.
 
The processes set out may be for an independent valuer to provide an opinion which is final and binding on the parties
 
Ultimately disputes may be taken through a process of litigation and be settled by the Courts with both sides to the dispute calling upon expert witnesses to provide opinions on value.
 
7. Can you outline any other methods available for dispute resolution?
 
Alternative Dispute Resolution (ADR) are processes for resolving disputes which are alternatives to litigation.  These can involve having a third party act as mediator or arbitrator.  Parties may prefer this method of dispute resolution as it may offer them greater control over the resolution process, maintain confidentiality and be cheaper than a lengthy court battle.
 
8. What are the most common valuation errors encountered?
 
This is an interesting question.  Things that spring to mind are where methodologies are applied too theoretically and without regard to the specific commercial circumstances or dynamics of a business or deal situation.
 
For example when applying a discounted cash flow method, too much focus can be placed on the calculation of the discount rate whilst giving insufficient consideration to the assumptions underpinning the cash flow forecasts.
 
For multiples based approaches, one common error is to apply a multiple which is based on the current earnings of a comparable company to the prospective earnings of the business being valued.  For companies where current multiples are high in anticipation of future growth, this can have the effect of overvaluing a business.