Business Valuation Part 5: Assets

How are assets dealt with in small business valuation?  Why do they feature prominently in some valuations and not others? In our previous posts we've discussed the over-riding principle used in the valuation of small businesses:

“A business is worth the sum of its future cash flows (if this is greater than the value of its assets)”

Businesses whose assets are worth more than the sum of their future earnings all fit into one of only two categories:

  1. Where the “sum of future cash flows” is low (usually because of a low multiple)
  2. Where the asset value is high

This video explains the different situations where this can occur, and how businesses are valued in each case. It also goes through some examples that are not included in this text.

Assets > Cash Flows

Asset sales are the most obvious category of business where this applies, simply because these businesses no long have any cash flows. Businesses that are closing down or have closed down and are selling their assets fit into this category, as do insolvency cases, where assets are sold to pay back creditors.

But many profitable businesses also fit into this category. Some businesses are profitable but are extremely reliant on the owner. Their personal brand drives all of the company’s business, and without them the company’s future earnings would be negligible. It is often difficult to sell these businesses at all, and if they do change hands it is for the value of their assets only.

Very small businesses that are profitable but not particularly stable will only warrant a very low multiple of their earnings, which would give a meagre valuation, often lower than the value of the assets. Very small shops and restaurants sometimes find themselves in this position.

Other businesses are capital-intensive and hold a lot of assets. Manufacturers, transport companies and rental companies are examples of businesses that hold lots of machinery and vehicles. For small businesses in these sectors, using a multiple appropriate for their small size gives a valuation that is close to or even less than asset value, not because their profits are low, but because the asset value is so high. 

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Selling for asset value only is an option, and in many cases this is the reality, but it is more of a last resort for the owner.  

Thankfully in these capital-intensive industries there is a third option: a hybrid valuation method, incorporating both earnings and assets.  In these specific industries the market will often pay more than asset value, and accepted Rules of Thumb exist for this reason.  For example, small trucking companies in the United States are often valued at:

2–3 x EBITDA plus Assets

And similar rules of thumb are often applied in the UK.

Some businesses hold a great deal of assets in freehold property.  We looked at some of these in the last video on Rules of Thumb. Small hotels, B&Bs, care homes, freehold pubs – all of these businesses have significant property assets. Their valuations are usually still calculated in the traditional way – they are based on their earnings, using the PE multiple method – the only difference is that with these industries the multiple tends to be higher than other small businesses, as we saw in the last video.  

However, sometimes the value of the property in these businesses starts to exceed the value of their future cash flows. This can either be because of falling earnings, or quite often because of rising property value. In these cases the value of the business is really the value of the property itself, so the property valuation determines the value of the business.

Some of these businesses can be separated from their property - they can move to rented premises to allow the property to be sold separately, or they can stay where they are and rent the property from the new owner.

Other businesses are dependent on their location and cannot be re-located without effort equivalent to starting from scratch.  In these cases, when the property value is greater than the valuation given by the earnings multiple method, the business is usually sold for the property value, and the business itself may be closed down, because the buyer wanted the property for a different reason.  For example, in the UK only 50% of freehold pubs that are sold continue to be used as pubs.  The remainder are used for other purposes, most commonly residential development. 

Asset Valuation

So how do we actually value the assets of a business?

In some cases it’s relatively easy – wherever there is a liquid market for assets, like vehicles, the valuations are pretty straightforward. Assets like kitchen equipment are traded on marketplaces like eBay, so it is relatively easy to estimate their values quite accurately. 

The value of stock or inventory is normally based on its purchase price, although the purchaser will usually try to negotiate a discount on the stock compared to the full price, especially where the stock is perishable or will be obsolete soon (fashion, technology). This is reasonable, and comes down simply to negotiation. Unique items like fixtures and fittings can be based on a percentage of their original purchase price if comparable products can’t be found on marketplaces, but again, much of this comes down to negotiation.

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Hiring a professional valuer or appraiser with experience in your specific asset classes can be very helpful, particularly where the values are high and the costs of error can be significant.  Expert valuers can be very helpful in providing a view on the value of used machinery for example, or specific inventory. 

Intellectual property assets are particularly difficult to value – industry experts can be consulted but the valuations will always be subjective. Most small businesses don’t hold IP like patents and trademarks, but some do, especially in the creative industries and in technology.  In some cases the value of this IP represents the bulk of the value of the company.

Reputational assets like trading history, search engine rankings, reviews and testimonials can be very important for a business, but are very difficult to value. These assets will contribute to a higher PE multiple for a business when it is valued the traditional way, based on its future cash flows, but they will usually not be valued as separate assets in their own right. 

Similarly, long-term contracts will usually contribute to the overall impression of the future earning potential of a business and result in a higher PE multiple. They can be valued as assets in their own right, but this is not very common. 

Leases

Leases, on the other hand, are contracts that do often have asset value in their own right, particularly for shops and restaurants. If these can be assigned to new owners, and if they are unique and will give the new owner an advantage, they will have value. A common example is where a small restaurant or takeaway business is selling before the end of its lease – if the location is desirable and the rental terms are lower than market rate, and if the contract allows for the lease to be assigned to a new tenant, then new tenants will be willing to pay a premium for the opportunity to operate a business at this location under the same lease. 

Rarely, the owner will close down the business, liquidate some of the assets separately and then look to assign the lease to a new tenant – effectively charging a premium for this favourable lease, as well as any fixtures and fittings that are left in the shop.

More commonly, the owner will look to sell the business as a going concern, with all of the fixtures, fittings and equipment bundled together with the lease and the goodwill as one unit.  Larger, successful restaurants and shops will be valued based on their future earnings, as we’ve discussed. But for very small shops with relatively modest profits, where the valuation based on future earnings would give a very low number, the valuation will be driven by the assets.  If the lease itself is considered desirable and can be assigned to a new tenant, then this will be one of the assets and the owner will charge a premium for this, along with a premium for “goodwill” in some cases. The eventual sale price will be negotiated of course, but the assets will be the driving factor in the value – especially the lease, if it is particularly desirable.

The exact premium that can be charged for the lease can be calculated using complex formulae similar to the discounted cash flow method – they basically add up the future savings offered by the beneficial lease and convert them into a present value. But in practice, this premium is simply based on how much the market will bear. Comparables can be useful in this regard – comparing the leases that have been transferred on similar properties in the same area, and the premium they were able to achieve, will give you a good idea. Commercial estate agents can give you an indication of this value, although the usual caveats around using agents should be followed. 

Bear in mind that if an owner is closing down his business and the lease he is looking to assign is actually unfavourable – in other words, the rent or terms are higher than market rate, or the location is undesirable – he will have to pay someone to take over the lease from him – he will have to pay them a “reverse premium”. Rather than an asset, the lease is a liability in this case.

One other point to note with shops and businesses that have a lot of stock – particularly perishable stock: this inventory is usually added to the valuation at the end. These valuations usually state the suffix “plus SAV” which means “plus stock at valuation”. Adding the inventory value at the end simply allows everything else to be negotiated first, without worrying about the stock level, which will fluctuate on a daily basis. The value of this inventory can also be negotiated of course, but it is left to the end in these cases.

Assets Vs Goodwill

Assets vs Goodwill

Remember that in the end, from an accounting perspective any price paid for the business in excess of the tangible asset value represents the “goodwill”. So whatever the circumstances – whether it is a hybrid valuation in the case of the transport company, or maybe a traditional PE Multiple valuation that gives a number greater than asset value, or maybe in the case of the shop a premium is charged for the “lease” – in every case, an accountant will simply call this “goodwill”.

So while we can have our reasons for stating why a business is worth more than its asset value, to an accountant, after an acquisition, none of these reasons matter. The buyer has simply purchased assets and “goodwill”.  

It’s sobering to remember that this goodwill is purely theoretical. A good case must be made by the seller for the buyer to buy it. If a buyer is going to pay more than tangible asset value for a business, then he has to really be confident in the future earnings that he is buying, and the opportunity that this represents.

Entry Cost Valuation

Before any buyer does this, there is one other type of valuation they will almost always do: the Entry Cost valuation. With this method, they will calculate the costs of starting an identical business from scratch, including buying assets of the same quality and quantity, and developing the business to the exact same state as the target they are considering acquiring, as an alternative instead of buying the business. 

If it will cost less to start a competitor from scratch and buy the equivalent assets (or in the case of a strategic buyer, to grow their own business by the same amount as the acquisition would add), and if the timeframe is acceptable, then it would be rational to do this instead. 

In reality, it is unusual for a realistic Entry Cost valuation exercise to show a favourable outcome – in most cases the time, expense, work and even luck involved in getting a business to an advanced state is worth paying for, rather than attempting to replicate it from scratch. But it is worth bearing in mind that this form of asset valuation will be conducted by most serious buyers.

Summary

When the assets of a business are worth more than the sum of its future cash flows, the valuation will be based on the asset value. This can be either because the asset value is high, the sum of future cash flows is low, or both.

Asset values can be particularly high in capital-intensive industries, where hybrid valuation methods are often used with small businesses, adding asset value to a low multiple of earnings. Businesses that hold a lot of inventory also typically add the inventory to the valuation at the end.

But in all of these cases, the business will not usually sell for less than asset value, because the owner has the option to liquidate the assets for this price.

Also remember that, regardless of the valuation method, buyers will always want to calculate the payback period on their investment – in other words, they will reduce the total valuation back to a multiple of earnings.  It is a good sanity check for sellers to do this too.