27 Jul 2020
Business Value Drivers Part 2
Continuing from our last blog post on the key business value drivers that help determine a company’s worth, we focus our attention now on the key components in business value.
For holding companies, the main business value driver would be the real estate asset or investment security that the company holds. Therefore, any increase in value on these assets will directly increase the value of the company. For the scope of our discussion, we will focus mainly on companies that are generating income through active business operations.
While it may be a daunting task to deconstruct a fully operating business, we will find that this is a necessary step. Not all pieces of this puzzle are valued the same when it comes to looking at the big picture of what a company is worth. In general, the business value drivers of a company include the following components:
- Working Capital
- Capital Assets
- Intangible Assets and Goodwill
- Redundant Assets/Liabilities
- Financing Liabilities (I.E. Debt)
The first business value driver is working capital (or net working capital “NWC”), which in its simplest form is the current assets less current liabilities of a company. Common constituents of NWC include:
- Accounts Receivable
- Prepaid Expenses
- Accounts payable and accrued liabilities
- Customer deposits
From a valuation perspective, NWC represents the optimal level of net assets in a company in order for the business to operate efficiently and effectively over its business life cycle.
The optimal NWC level depends on the industry the company operates in. There are industries where a nominal level of NWC is contemplated (e.g. insurance brokerages) while others require a set level of NWC each period in order to operate effectively (e.g. grocery stores).
From a valuation (and M&A1) perspective, excess NWC above the optimal level would typically translate to an increase in business value, on a dollar for dollar basis. Likewise, a deficiency in NWC below the optimal level would translate to a decrease in value, on a dollar for dollar basis.
Capital assets are another business value driver. These include equipment, machinery and furniture used in the day to day operations of a business. Depending on the industry the business operates in, the level of capital assets employed can vary significantly.
For example, it would not be surprising that a manufacturing company would require far more machinery and equipment to operate than an accounting firm. Similar to working capital above, the valuation of a business usually incorporates in a normal amount of capital assets required to operate; any excess or unused machinery and equipment (e.g. not essential to the operations) are added on top of this business value (i.e. the business enterprise value of BEV).
Intangible Assets and Goodwill
Intangible assets and goodwill are also business value drivers. As the names suggest, they reflect business assets that are not physically tangible. Intangible assets and goodwill include:
- Customer and Vendor Relationships
- Brand Name and Identity
- Operating Licenses
- Intellectual Property (E.G. Copyrights, Trademarks, Etc.)
- Business Systems and Processes
- Trained Workforce
From a valuation perspective, the business’s optimal working capital, capital assets, and intangible assets and goodwill collectively make up what a company’s business is worth.
Other business value drivers include redundant assets (or liabilities), which are balance sheet items that are not necessary to the ongoing operations of the business (i.e. assets that do not contribute to business earnings or generates a cash flow stream that is at a significantly different risk level than that of normal operations).
Common redundant items include:
- Marketable Securities
- Property (I.E. Land and Building)
- Shareholder Loans (Receivable or Payable)
- Related Party Loans
Excess cash and excess NWC would also be considered redundant if these assets remain idle or can be redeployed without impacting the normal operations of the business. Unlike working capital, capital assets, and intangible assets discussed above, redundant assets (or liabilities) do not impact what the business is worth. Instead, redundant assets and liabilities impact the value of a company’s shares as illustrated in our chart below.
Financing liabilities, namely debt, include loans undertaken to finance key assets used in the business such as machinery and equipment. In our experience with this business value driver, it is not uncommon for businesses to also borrow funds to finance working capital given the low interest rates observed in today’s market.
While similar to redundant assets whereby financing liabilities do not impact the value of the business, the dollar amount of debt on the balance sheet is deducted in determining the value of the company’s shares.
The chart below summarizes the different building blocks of a company, indicating the business value drivers that make up the value of the company and the additional layers that are considered in determining the value of the overall business (i.e. the company’s shares).
In the purchase or sale of a company, an asset purchase or sale allows for the purchaser to select the business assets they would acquire. Consequently, the closing price in an asset purchase or sale would generally gravitate around the business enterprise value as the purchaser will typically refuse to take on the excess idle assets and/or debt in the company.
If a share purchase or sale was contemplated, the closing price will be the en bloc value (i.e. the value of the company as a whole).
In our next blog on business value drivers, we finish off our three-part series with improvement focus areas to assist owners in achieving a higher value for their business.
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If you have any questions on how to value your business at this time, please contact William Tam, CPA, CA, CBV directly.
This content is believed to be accurate as of the date of posting. Canadian Tax laws are complex and are subject to frequent change. Professional advice should be sought before implementing any tax planning. Manning Elliott LLP cannot accept any liability for the tax consequences that may result from acting based on the information contained therein.