Features
Nick Martindale 8 Sep 2017 10:55am

Flotations and valuations

Setting a fair price for a business is no easy matter, and needs to factor in the type of sale, the nature of the sector and the potential for future profits, as well as what the market will tolerate. Nick Martindale outlines how companies try to identify their true value

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Caption: The high-profile flotation of Snap Inc, the business behind disappearing messages app Snapchat, was worth $28bn

The high-profile flotation of Snap Inc, the business behind disappearing messages app Snapchat, for $28bn – just a few months after Microsoft acquired LinkedIn for $26.2bn – serves not only to underline the huge value placed by investors on a company’s potential, but also the rather arbitrary world of business valuations (since the Snap initial public offering, investors have become concerned it might never become profitable). “Valuations are a measure of risk and return, and different investors are likely to put different weightings on each,” says Richard Bibby, head of valuations in Europe at Alvarez & Marsal. “If you were to give 10 valuers the same information on a private company and ask them to value it, you would likely get 10 different answers, given there are so many variables to work with.”

There is at least some logic, however, behind valuing businesses, particularly those looking to float in an IPO. “The first port of call is comparable valuations, so how other companies in the sector are being valued,” says Marco Schwartz, head of UK equity capital markets advisory at KPMG. “Then you look at the comparables and the IPO candidate and see if there are any particular elements of your IPO candidate’s equity story which makes it different and therefore justifies a different valuation or angle.” Differences can emerge across sectors, he adds, especially around whether businesses are targeting yield or growth.

Cases such as Snap, however, where the business has yet to demonstrate any sustained track record of profitability yet has huge potential in terms of technology and user base, are the exceptions rather than the norm, even if we can expect similar disruptors such as Uber or Airbnb to follow. “Snapchat has arguably taken over, as shareholders have argued, as a dominant form of communication for a particular demographic,” contends David Petrie, head of corporate finance in the Corporate Finance Faculty at ICAEW.

“Investors are buying into a social trend or a societal norm as opposed to buying into a business. That has very significant value but it’s difficult to quantify because the business has been investing heavily in growing its customer base and has yet to see a cash return on that investment. People are speculating that in the future there will be a way of monetising that, but that is their risk.”
This means it’s entirely feasible that such businesses could be worth more than those with established business models and tangible assets, says Jeffrey Davidson, managing director of Honeycomb Forensic Accounting. “With a bricks-and-mortar company one can usually see what gives it its value, but growth is slow,” he says. “Each new customer needs to be fought for and worked on. The investment in each brick is quite high. The investment in each additional customer of a tech company is virtually nil, and the growth trajectory can be stupendous.”

Yet it is a double-edged sword. “The problem is that the overall marketplace might not have enough space for every technology to succeed, or for every successful ‘free’ technology to attract income-generating activities,” he adds. “In value terms, companies competing for market share of social media, advertising or cross-selling are either going to be huge, or nothing. There’s not really much in between.”

Nick Atherton is MD of Morphose. He draws a parallel between the current market activity and the dot-com bubble of the late 1990s, although adds that the latest investment trend appears to be based on more stable foundations. “Snapchat’s flotation was staggering, but the business model indicates a plan for the future that somewhat justifies its huge sale price,” he says. “While other large technology platforms are competing incessantly with software feature innovation to attract new users, Snapchat is now beginning to focus more on in-app purchases and hardware that make its offering more attractive and profitable for investors.” Investors have clearly seen enough potential in such technology firms to justify the investment, he adds.

A degree of rationale can be applied to valuations in such cases. “Potential can seem like an abstract concept when valuing a technology business, but there are ways to calibrate the possible value of a company based on the business model, the competitive landscape it operates in, its key differentiators and the addressable market,” says Rory O’Sullivan, managing director of Duff & Phelps. “Once you have an understanding of these elements you can forecast estimated revenue and earnings, and extrapolate the future value of a company, which you then discount back at an appropriate rate reflecting the risk to arrive at a fair value today.”

Schwartz believes a new method is required for such cutting-edge firms. “On the one hand we have bricks-and-mortar companies with assets with bottom-line profit generation,” he says, “and on the other hand we have very different companies which don’t have assets that are looking for ways to make profit or are not even revenue-generating. I don’t think people have really got their heads around how to value these. We haven’t seen these companies that have great ideas and long customer lists, but have been unable to generate either revenue or profit, mature. It needs a different valuation of growth.”

Valuing businesses for private sales brings a different set of challenges. A good starting point, suggests Petrie, is to identify similar firms which are listed, and then discount from there. “The conventional argument is that a business that is not listed trades at a discount to one where the shares are readily saleable, and that is usually about 30% from a similar listed company,” he says. “That’s been the way large private businesses have been valued for a long time.”

One of the issues, says Atherton, is that there are many different yardsticks which can produce significant variations in a company’s worth. “Generally speaking, historical income will largely determine how a value is determined, but there are other methods that can offer considerably different outcomes during an assessment,” he says. “Part of the difficulty is in establishing which of these methods is most appropriate for a given set of circumstances. Asset, market or income strategies will all draw up vastly different conclusions.”

The ultimate measure for any investor will be the expectation of future growth in earnings, although this is obviously impossible to predict with any degree of certainty. “Neither buyer nor seller are interested in the past performance of a business, except perhaps as an indication of future performance,” points out Davidson. “The marketplace, as well as analysts, will move the price up or down depending on the perception on any given day. An announcement of a new customer, a deal or a new market for a company will drive the price up; an adverse announcement will drive it down.” Anyone involved in buying or selling will also need to factor in just what level the market will bear, he adds, and meet the parameters of what both parties are looking to achieve.

Listed firms can also be tricky to value, even though there is an openly traded market which should serve to ensure a greater degree of consistency than may exist with either an IPO or a private sale. “The valuation of the listed company will result from the current share price at which that company’s shares are trading, and this may not always be reflective of the underlying trade in that company,” points out Helen James, partner at chartered accountants HW Fisher & Company.

“If there is no liquidity in the shares, or it is listed on a junior exchange where there is little trade, you could find that the shares are traded at a lower price and the company is valued at a lower amount than a similar private company, as a result of both the lack of liquidity or the costs associated with being a public company.” Such valuations can also be affected by wider economic changes outside of the control of any individual business, she adds, such as a sudden stock market surge, and this in turn can affect the multiple applied to a private valuation of an unlisted company.

Both accountants and valuations advisers have an important task to play in helping individuals and businesses prepare for a sale or acquisition, and in ensuring the price paid is one that reflects market worth. “There is a role for accountants, sometimes with economists and financial modellers, in providing independent, critically analysed valuations, where the thought process is transparent and open to verification,” says Bibby. “Accountants tend to have both the critical financial understanding to assess the quality of the information, the technical skills to do the number-crunching and analysis, the broad commercial experience to put it all together and get it right, and the intellectual resources to present it all properly.”

This can also extend to helping business owners pick the right time to sell, says Petrie, including identifying both market and wider economic conditions as well as the individual’s own circumstances. “There will be an optimum time in the lifecycle of companies when they are most highly regarded and valued; where they either command the most significant profit margin or sales are growing at the most spectacular rate,” he says. “But they have to align that with some of the personal considerations, as well as the political risk and the current tax system. The decision to sell can be a complicated one.”


SEALED BIDS

 When Richard Gundle, former second-generation owner of family business Field and Trek, decided in 2007 that it was the right time to sell, he took the unusual step of approaching a number of organisations which he thought would be interested.

“In the information memorandum we constructed it so that the benefits that each of the individual businesses would get from it were obvious,” he says. “There were options to buy parts of the business and leave others behind, because in some cases it could be worth more to them by doing that.”

Gundle, who now owns industrial shelving business Tufferman, decided not to place a value on the firm, instead inviting interested parties to submit bids, and the business was eventually sold to Sports Direct in a deal worth around £6m. “We asked 12 companies and eight said they were interested,” he says. “We got a much higher valuation through that method than we would have done if we’d just put it up for sale on a basic multiplier. It was probably not far off double.”
He believes he also benefited from using a boutique firm rather than a larger organisation to handle the sale, and financially incentivised those working on the deal to ensure it went through at a good price. “If they were on a flat fee, whether they got an extra £1m wouldn’t make any difference to them, but it would be life-changing to me,” he says.

He does stress that it’s important to be realistic. “It would be really easy to start chasing an even higher valuation and never actually get the business away,” he warns.


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