Business valuation in Africa made easy by the Optima valuation model

Business valuation defined

A business valuation is the systematic collection of information and data related to a business and its owner(s) to assign a fair price to it. Apart from the differing views from the 'seller' and 'buyer' on the worth of the business, the subjectivity is further influenced by the prevailing economic climate and the intangible business value.

Valuations in Africa

In Africa, compared to developed parts of the world like Canada and the United States of America, very little historical data exists for business valuator's on which to base their decisions. Whereas in the more developed parts of the world specific standards exist along with the necessary statistical information on which to base decisions.

Thus very often a business valuation in Africa is based on:

• Gut feel
• Industry norm
• A pre-conceived notion of price
• A broker's need for a price that justifies their commission
• A seller that believes the business is worth much more; or simply
• An estimation.

The point is, very often business valuations are based on little fact and mostly fiction. Thus businesses are either not sold because of excessive prices, or do not survive the sale as the expenses in the capital structure changes in such a way (due to an excessive price and related costs of financing) that the business cannot support its own cost structure and soon fails after the sale.

Worse still, sellers occasionally systematically and artificially inflate their sales volume, gross profit margins and even net profit margins for some time before a business sale to exaggerated the price when the time comes to sell.

Similarly an owner may be aware that the business has reached the peak of its life cycle and is about to enter a decline and thus want to sell, however the seller is loath to reveal this crucial information to the buyer. Thus, the adage of "buyer beware", rings true.

The Optima business valuation model

The Optima business valuation model is based mostly on commonly used business valuation techniques. It is advised that training on the use of the model be sought before actively using it.

The model requires subjective inputs and does not predict values, rather it:

• Calculates a value based on the valuator's inputs
• Provides a possibility to examine these assumptions; as well as
• The effect on the value of the business.

Thus, the model still relies on quality inputs to work. The adage of garbage in, garbage out holds true and a valuator must be aware of the drawbacks of each method. To simply apply the model without understanding the background is dangerous as outcomes may very well be completely incorrect.

The factors considered in the valuation model are:

• Legal structure of the business
• Age of the company (the younger the more risky)
• Number of years owned by the current owner (the shorter the period the more questionable the sale)
• Cost of debt and equity
• WACC (calculated by the model)
• The past growth of the business; and
• Risk factors.

Risk loadings

Risk loadings indicate identified risks for the business linked to a specific method, including:

• Owner's reasons for selling
• Length of time the company has been in business
• Importance of owner drawings
• Degree of risk reflects the general investment environment of the business; and lastly
• Profitability, location and growth history.

Earnings before interest and taxes days (EBITDA)

The EBITDA and its relevant risk loadings include the stability of the industry in terms of:

• A good historic growth rate similarly warrants a high score
• Next the elasticity of price is considered
• Capital intensive businesses; and lastly
• Barriers to entry.

Return of investment (ROI)

The ROI risk loadings include:

• Business risk is again similar to a general level of environment risk and is a subjective assessment of the business and its risk environment
• Franchises generally hold lower risk as they create a more suitable business environment for stability
• The Investor's risk profile with regards to the level of their risk appetite
• Financial structure considers the level of debt and gearing in the business
• Working capital turnover rate, WACC are self explanatory; and also
• The average return for the industry.

The capital structure of the business

The capital structure, including the gearing of the business, will have a significant effect on the valuation. Therefore necessary adjustments must be made before entering the information. The balance sheet used to enter the information is a condensed version.

Monthly sales

This information should similarly be as accurate and to the point as possible.

Income statement

On the following page the data from income statements should be entered. Wherever possible, audited statements should be used.

An estimated business valuation

Lastly, the Optima business valuation model generates an estimated valuation given the data provided. Each valuation can then be adjusted to see the effect of changing certain key inputs using a sensitivity analysis.

By adjusting the sensitivity up or down the effects and the resulting changes can be seen. Such a sensitivity analysis is a powerful tool not only for identifying problems but similarly to understand the business's strengths and weaknesses.