Understanding Valuations
Understanding Business Valuation Through Financial Statement Reconstruction
Introduction to Business Valuation
Business valuation is the process of determining the economic value of a business or company. While historical financials provide a foundation, the true value lies in the business's ability to generate future economic benefits. This is especially important for small and medium enterprises (SMEs), where financials may be optimized for tax efficiency rather than transparency.
To accurately assess value, financial statements often need to be reconstructed to reflect the true commercial performance of the business. This involves adjusting reported figures to remove distortions and reveal the Adjusted Net Profit, a more accurate measure of earnings.
Reconstructing Financial Statements
Closely held businesses often include personal expenses, non-recurring costs, or tax strategies that obscure true profitability. Reconstructing financial statements involves:
- Adjusting income statements to add back owner compensation, depreciation, interest, and non-operational or one-time expenses.
- Normalizing expenses to reflect market-based salaries and costs.
- Creating a clearer picture of the business’s operational cash flow.
The result is the Seller’s Discretionary Cash Flow (SDCF), which is widely used in SME valuations.
Seller’s Discretionary Cash Flow (SDCF)
SDCF is a standardized measure of cash flow available to a single owner-operator. It includes:
- Net profit before tax
- Owner’s salary and benefits
- Depreciation and amortization
- Interest expenses
- Non-recurring and non-operational expenses
- Adjustments for market-rate management costs
This metric is crucial for comparing businesses across industries and is often used in valuation multiples.
Forecasting and Valuation Methods
Once financials are reconstructed, a 5-year forecast is typically developed based on growth assumptions. These projections help apply income-based valuation methods, which include:
- Discounted Cash Flow (DCF) – Projects future cash flows and discounts them to present value.
- Multiple of Adjusted Net Profit – Applies industry-standard multiples to SDCF.
- Capitalization of Earnings – Converts a single period’s earnings into value using a capitalization rate.
- Price/Earnings Ratio – Compares the business’s earnings to its market value.
Each method has strengths and is chosen based on the business type, size, and available data.
Practical Insights and Cautions
- Data Accuracy: Valuations rely on accurate financials. If statements are unaudited, caution is advised.
- Industry Multiples: Use sector-specific benchmarks. For example, service businesses average a 2.48 earnings multiple.
- Professional Help: Engage brokers or valuation experts for complex cases.
In conclusion, reconstructing financial statements and forecasting future performance are essential steps in valuing a business.
These practices ensure that buyers and sellers have a clear, fair understanding of a company’s worth.