Valuing small to medium enterprises (SMEs) is different from valuing large, publicly listed companies due to differences in ownership structure, management involvement, financial record-keeping, and the influence of personal factors on the business. SMEs are often more closely tied to their owners, have less formal financial practices, and may be driven by lifestyle or independence motivations.
Principles of SME Valuation
Sloan and Macleod (2004) identified three key principles that underpin SME valuation methods:
1. Principle of Reproduction
This principle is asset-based. If income-based valuation methods yield a lower value than the net realizable value of the assets, an asset-based approach may be more appropriate. This is because income-based methods might undervalue businesses with inconsistent or poor earnings, while an asset-based approach can establish a minimum value based on tangible assets, making it a more reliable choice in such cases. The asset-based approach essentially values the business as though it were to be terminated—a method opposite to that of a going-concern valuation.
- Notional Realization of Assets Method: Appropriate for businesses with a poor earnings history or an uncertain future. Involves orderly sale of the business’s assets (not a forced “fire sale”).
- Cost of Replacement Method: Estimates the cost required to replace the existing assets of the business with equivalent new assets, providing an estimate of what it would cost to build a similar business from scratch.
2. Principle of Anticipation
The income-based principle is the most common approach for SMEs with a stable income flow. Valuation under this principle is determined by assessing future economic benefits, such as cash flow or earnings, and discounting them to their present value.
- Multiple of Discretionary Earnings Method: Uses EBPIDT (Earnings Before Proprietor’s Income, Depreciation, and Taxes) as a base, expressing the value as a multiple of these earnings.
- Capitalization of Earnings Method: Used when future earnings are expected to remain consistent. Capitalizes expected earnings by applying a capitalization rate that reflects risk and growth prospects.
- Capitalised Dividends Method: Values small minority holdings by capitalizing the projected dividend stream.
- Discounted Cash Flow (DCF) Method: Captures the value of fluctuating cash flows over time, providing a more flexible valuation compared to methods assuming stability.
- Excess Earnings or “Super Profits” Method: Calculates ‘excess earnings’ after deducting financing cost for tangible assets and a market-level salary for the owner-operator, then capitalizes these earnings to determine overall business value.
3. Principle of Substitution
The market comparison approach involves comparing the business to similar enterprises that have recently been sold. Though challenging due to limited market data for SMEs, tools like Bizstats can help benchmark similar businesses effectively.
- Comparable Transactions Method: Uses data from comparable transactions to estimate the value of the SME.
- Rules of Thumb Method: A simplified approach using industry-specific valuation multiples (e.g., revenue or earnings) to provide a quick estimate.