How do investors value a business they want to acquire?

People who acquire a business as an investment ask the same question as any other buyer: what is this worth to me? Business valuation for investors in Canada follows a recognised toolkit, and BDC, the Business Development Bank of Canada, describes it in plain terms. It says three main methods are frequently used to determine the value of a company. This guide explains what those methods look at, why the results differ, and what an acquirer can do with a number once there is one. It is general information, not a valuation and not advice on any deal.

Three families of method, one purpose

BDC groups the methods as earnings-based, market-based and asset-based. Earnings-based methods review forecasted earnings or cash flow alongside past results. Asset-based methods value what the business owns. Market-based methods look at what comparable businesses have sold for. BDC adds that a valuator may use one or more of them depending on the available information and the type of business and transaction. The most suitable combination depends on the purpose of the valuation and on the company’s characteristics, such as its profitability, future outlook and asset mix.

Starting with earnings

BDC says business valuation often begins with assessing operating earnings. It says the most common method used to determine a fair sale price is calculating a multiple of EBITDA, which is earnings before interest, taxes, depreciation and amortization. The glossary entry on EBITDA explains the measure itself. BDC describes it as a measure of a company’s ability to generate operating earnings. The multiple is not fixed. In its article on valuation methods, BDC files multiples under market-based methods and says the ratio used depends on factors such as the industry and size of the company, market conditions and the multiples paid for comparable businesses.

Cross-checking the first number

BDC says professional valuators commonly use multiple valuation approaches to confirm a fair price. It says that after arriving at the EBITDA-based figure, a professional business valuator typically seeks to confirm it by applying other approaches. The first check is the value of the company’s tangible and intangible assets. The second is what comparable businesses sold for. This matters to an acquirer because the checks can point in different directions. BDC notes that each method may yield a different value. If the earnings figure and the asset figure sit far apart, that gap is a question to put to the valuator, not a number to average away.

Adjusting the earnings before using them

Reported profit is not always the earnings an acquirer would inherit. BDC lists failing to normalize earnings among the common valuation mistakes. Normalizing means adjusting for special factors, such as discretionary and non-recurring items and revenues and expenses that are not at market rates. Ask the seller for the books behind each adjustment, and ask your own accountant whether the adjusted figure would hold up under your ownership. Recasting is a judgement, so the person doing it should be able to show their working. A buyer who accepts the seller’s adjusted figure without testing it is relying on someone else’s assumptions, and the valuation inherits every one of them.

Why value, price and your own number differ

BDC says a potential buyer may have a different value in mind than the company’s owner. It also says the final transaction price often differs from the valuation, and that many factors influence it: how keen the seller is, the buyer’s strategic interests or expected synergies, available financing, due diligence and the company’s ability to transition smoothly to new ownership. BDC also warns that buyers can pay a premium for expected synergies, and that buyers often underestimate the costs of an ownership transition and overestimate savings from a merger. Treat synergies as a hypothesis to test, and ask what evidence supports each one before it enters your own estimate of what the business is worth to you.

• Ask which method the valuation relies on and why that method suits this type of business.
• Ask for the earnings adjustments in writing, with the records behind each one.
• Compare the earnings-based figure with the asset and comparable-sale checks, and ask the valuator to explain any gap.
• Ask what the lender’s own valuation shows, since BDC says a bank’s valuators value the business to see how much financing it will provide.
• Keep your estimate of synergies separate from the standalone value of the business.

Choosing who does the valuing

BDC suggests asking your accountant, lawyer and others in your network to recommend valuators they have worked with, and says it is a good idea to choose someone who holds the Chartered Business Valuator designation. It adds that when a valuator is hired as part of a business transfer, it is good to choose one both parties agree on. In some cases, BDC says, a valuator may not even be needed. CBV Institute, the profession’s body, states that CBVs are recognized by regulatory, judicial and tax authorities in Canada as experts in business valuation. For a wider view of the subject, see how to value a business in Canada.