Dada Adefolami

By Dada Adefolami

Business valuation is a process and a set of procedures used to determine what a business is worth. In finance, valuation is the process of estimating what something is worth. Items that are usually valued are a financial asset or liability. Valuations can be done on assets (for example, investments in marketable securities such as stocks, options, business enterprises, or intangible assets such as patents and trademarks) or on liabilities (e.g., bonds issued by a company).

Economic conditions affect what people believe a business is worth. When jobs are scarce, more business buyers enter the market and increased competition results in higher business selling prices. The circumstances of a business sale also affect the business value. There is a big difference between a business that is shown as part of a well-planned marketing effort to attract many interested buyers and a quick sale of business assets at an auction.

Earnings & profits (E&P) is the measure of a corporation’s economic ability to pay dividends to its shareholders. An up-to-date E&P calculation is important for many corporate transactions, including determining whether a distribution to shareholders is a taxable dividend.

The two main methods of valuing a trading entity are the earnings-based approach or assets-based approach, although other methods suitable for a business trade or circumstances are also available, the discounted cash flow approach. Ownership is important so when valuing an interest that is less than a 100% interest, it may be appropriate for that interest to be discounted from the full pro rata value.

Earnings-based approach
What multiple SHOULD APPLY to the earnings?
Price/earnings ratios (P/E ratios) are calculated by reference to post-tax earnings. A P/E ratio is the relationship between the post-tax earnings of a business and its capitalized value. For example, if a business is earning N100, 000 per annum post-tax and is sold for N1m, then the business is said to be sold on a P/E ratio of 10.

As an alternative to a P/E ratio, an earnings before interest, taxation, depreciation and amortization (EBITDA) multiple can be used. Also, turnover multiples can be used in certain circumstances, such as professional practices.

Making an adjustments to earnings
When valuing a standalone business, historic and future earnings can be affected by any one-off, non-recurring or other abnormal entry. Some common examples are as follows:
1. Directors’ remuneration not at a commercial rate.
2. Bad debts either unusually large or small.

It may be that the company has income from other sources (such as rental income) which is not part of the core business activity to be valued. If the business is valued on an earnings basis, then the income from other assets is removed from that computation and the value of the relevant assets are added to the final valuation.

If the company is part of a group then there are additional factors which need to be considered, including the following more commonly seen issues:

1. Intra-group trading needs to be on a commercial and arm’s-length footing.
2. Intra-group financing needs to be on an arm’s-length basis with appropriate interest charged.
3. Intra-group charges such as service charges, directors’ remuneration and the like need to be on an arm’s-length basis.
4. Intellectual property rights owned by one Group Company and used by another should result in an appropriate license fee being charged.

Some trading companies hold assets with a considerable value, such as property developers and farming companies. The minimum value for such companies is likely to be the sum of the assets that they hold. It may be appropriate to add to that minimum value a further sum representing goodwill.

Assets-based approach
Asset-based approaches should be considered where either the business is loss-making, is making a very poor return on assets or is in a break up situation. If the company is loss-making but can still be considered a going concern, the valuation should adjust any material assets to reflect current market value. A discount to the net asset value may be appropriate to reflect the likelihood of losses in the future.

If the company is only making small profits compared with the net asset value, and the application of a P/E ratio or other multiple will produce a value less than the adjusted net asset value, then the valuation would normally be based on the net assets. No further discount would normally be required to reflect future losses.

If the company is in a break up or other distress situation it would normally be assumed that creditors need to be paid in full, but assets would be reduced in value to reflect the fact that the company is in distress.

In some cases it will be necessary to engage a valuer to value material assets such as property, plant and machinery, intangible assets, growing crops and livestock. Contingent tax liabilities may need to be brought into the valuations. The following issues need to be considered in deciding how much of the contingent tax charge should be deducted:

1. When an entire property company is being sold, the vendor and purchaser often begin negotiations on the basis of a 50:50 split of the contingent tax between themselves.
2. When the company owns many properties and is regularly engaged in disposal and replacement of properties, then a large percentage may be appropriate.
3. If the company owns a single commercial property and has no history whatsoever of property disposals, then it might be that only a very small proportion of the contingent tax would be deductible.
4. When negotiating valuations with Revenueauthority, an appropriate allowance will be provided.