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Valuing a business in a recession

Clinton Cards

Everyone is fully aware of the impact on property values and global stock markets caused by the credit crunch and recession, which at present show only a weak sign of recovery.

However, is it simply property and listed company values which have suffered? Has the value of the average SME been equally affected?

In considering these questions it is important to emphasise the following:

  • In the absence of a market such as a stock exchange, the value placed on a business is likely to be influenced by a number of factors and any two valuers faced with the same valuation to undertake, will not necessarily arrive at a similar figure as a result. Professional judgement will play an important part, however factors such as geographic location, competition, market share, surplus assets etc, may be relevant.
  • The recession has hit different sectors to varying degrees. It is well documented that house builders have been badly hit with many proposed developments put on the back burner and the effect on bank stocks is well documented.  However, some niche businesseshave been largely unaffected by the recession and some may have actually benefited.
  • The credit crunch has undoubtedly had a considerable effect and even if a willing purchaser does show their face, can a lender be found willing to finance the purchase? The noises from central government might be along the lines that the lenders are being encouraged to lend (especially those in which UK plc now has a stake) but try getting a lender to sign off a lending proposal.

    If lending can be achieved at a rate of 5%, a potential acquirer may be happy to accept a rate of return of 15%, thus providing a 10% buffer for the risk involved

Every business is different and generalisations can give an inappropriate view. However, historically a large number of SME acquisitions took place based upon a multiple of adjusted post tax profits of between 4-8.

In the current environment this range has somewhat fallen and 2-6 tends to be the present norm. Some businesses will continue to achieve well above six and even eight, but this is likely to be due to special circumstances of either the business itself or the potential acquirer.

Surplus assets such as cash deposits or investment property together with, market penetration, new products etc, are examples of such special circumstances.

Risk buffer

What is very interesting is the relationship of the bank base rate and the returns which potential acquirers look for. When interest rates are low, the rate of return an acquirer will accept tends to be lower.

For example, if lending can be achieved at a rate of 5%, a potential acquirer may be happy to accept a rate of return of 15%, thus providing a 10% buffer for the risk involved. This would suggest a multiple of adjusted post tax profits of 6-7.

However, if lending is going to cost 10% and the same differential is required, a 20% rate of return would suggest a multiple of 5 and if a higher differential is required because the risk is considered to be greater, a 25% rate of return equates to a multiple of four.

It can be seen from the above, that historically when interest rates are low, the multiple achieved tends to be higher and when interest rates are high the multiple is lower.

The current situation is therefore unusual in that the Bank of England base rate is at 0.5% which should result in high multiples being achieved, but a combination of the credit crunch and wider recession are keeping multiples low.

BDO Stoy Hayward publish quarterly their Private Company Price Index (PCPI) which reflects deals which they are aware of in the market and provides an arithmetic mean multiple based upon unadjusted post tax profits.

This index reveals a fall in the mean multiple from 14.8 in 2007 to 12.1 for 2011, which in itself is an improvement on the previous year.  Further, the number of deals involved shows a dramatic fall from circa 800 a quarter through 2007 to 430 a quarter through 2011.

In conclusion, it is evident from the PCPI that the recession and related credit crunch have had a significant effect on both the value of businesses and the number of deals around, with multiples achieved showing a fall of some 20% and the number of deals reducing by 50%.

There are however some around who will see the reduction in values as an opportunity, especially if they are sat on large cash deposits which are earning very little, with no short term indication of interest rates returning to their pre recession levels.

Goldsmiths Corporate Finance  can be contacted for help with buying and selling businesses on 01628 627 637 

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