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Practical tips for the valuation of SMEs

The valuation of small and medium-sized enterprises (SMEs) presents experts with a complex problem. Can multiple valuations replace the DCF and Income approach? In this article, we shed light on the challenges and possible solutions when valuing SMEs.

Written by

Peter Schmitz

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Taxes

Assessment Practices

Category

Business valuation
TABLE OF CONTENT

The valuation of small and medium-sized enterprises (SMEs) presents experts with a complex problem. Can multiple valuations replace the DCF and Income approach? In this article, we shed light on the challenges and possible solutions when valuing SMEs.

Challenges in the valuation of SMEs

The valuation of small and medium-sized enterprises (SMEs) presents tax consultants and auditors with various challenges. On the one hand, this is due to the selection of the right valuation method for the valuation occasion and, on the other hand, due to the implementation of the discounted cash flow (DCF) or income approach that is required in many cases. When valuing SMEs, the latter entail the need to form a group of often seemingly unsuitable listed peer companies (peer group) to determine the beta factors.

Valuation theory and practice recognizes various methods for determining the value of a company. The most frequently used methods are the net present value and market methods. The capital value methods include the DCF method and the income approach. The market methods include the various multiples methods, which also include the simplified income approach in a modified form. Individual value-oriented and special approaches tailored to the occasion and the sectors (e.g. for medical practices) are used much less frequently.

Can multiples valuations replace the DCF and Income approach in the context of SME valuation?

In the course of clarifying the valuation of small and medium-sized enterprises, the Institute of Public Auditors in Germany (IDW) clarified (IDW Practical Notes 1/2014) that simplified valuation methods cannot replace a business valuation in accordance with IDW S1. Their use as a plausibility check method was confirmed, but the application of cash flow or income-oriented discounting methods is still necessary in the context of determining objectified company values.

This clear IDW requirement is essentially derived from the fact that the simplified pricing methods cannot fully reflect the complexity of a company's value. To put it bluntly, the multiple valuation can be interpreted as an attempt to reflect all the factors influencing the value of a company in two figures, the multiple and the earnings figure. This can form an acceptable basis for a value indication and can be used to check plausibility, but cannot replace an exact determination of value.

Challenges with DCF and Income approaches: Planning calculation and methodology

The first thing to mention here is the need for a planning calculation. While simplified pricing methods are often based on historical business figures, the application of the capitalized earnings value and DCF methods requires a concrete forecast of the company's earnings, assets and financial strength over a period of 3 to 5 years. In addition to planning the operating earning power, this also includes planning the key balance sheet items, first and foremost tangible and intangible assets and net current assets. Finally, the valuer must form an opinion on the sustainable profitability of the valuation object.

A further challenge lies in the methodology for determining the value of the net present value method, which is fundamentally more demanding than that of the simplified pricing methods. These generally consist of a simple multiplication of an earnings figure and a multiples. The user only has to ensure that the earnings figure and multiples correspond to each other. Within the framework of the net present value method, the valuer must ensure consistency of the variables used, as in the multiplier valuation, but must define and calculate several variables and coordinate the definition of the earnings or cash surplus, the deductions or additions and the discount rate.

The biggest challenge with DCF and Income approaches: Determining the correct beta factors and discount rate

Compared to the need to prepare a budget and the complexity of the method, deriving a discount rate in line with the market often proves to be the greatest challenge. Many valuers are used to dealing with budgeted figures from their daily professional practice. There are a number of inexpensive tools on the market for methodical valuation. For the discount rate, however, the valuer needs capital market data.

Determining the beta factors on the basis of a listed peer group

The IDW S1 standard provides for the determination of the capitalization rate on the basis of the Capital Asset Pricing Model (CAPM). An important component of the capitalization rate is the beta factor, which is calculated using the share prices of publicly traded companies. In valuation practice, the usual procedure is to compile a group of publicly traded companies (peer group) and apply their beta factors to the company to be valued.

The composition of the peer group is strongly influenced by the subjective assessment of the valuer and must therefore be viewed critically when determining an objectified company value as defined by IDW S1. However, it is undisputed that even in the case of "difficult comparability", the enterprise value must ultimately be determined on the basis of the CAPM and using a beta factor.

The search for peer companies for the peer group

In the context of SME valuation, it is often argued that there are no comparable publicly traded companies for the valuation object. In fact, this argument is usually incorrect, as in most cases a peer group can be compiled from publicly traded companies.

If only a few comparative aspects are considered (e.g. product mix, regional focus and company size), it is rare for publicly traded companies to be identical to the SME being evaluated. It is therefore important to consider other influencing factors. The beta is an indicator of the risk that market participants can expect. It is therefore important to find comparable companies that have a similar business risk.

Special databases can be used to fulfill this task in the best possible way. It is important to be able to search specifically for various factors such as company activity, sectors or company size. Databases from providers such as Bloomberg, Capital IQ and smartZebra make this possible. While the well-known US platforms are geared more towards share trading and investment banking, specialized German providers offer solutions tailored precisely to the needs of valuers.

Search strategies for difficult cases

Various strategies can be used in the search for companies with a comparable business risk:

  • Horizontal: Search for very similar companies that operate in other markets. There are only a few listed private hospitals in Germany, but they are comparatively common abroad.
  • Vertical: Search for companies that are upstream or downstream in the value chain. In other words, suppliers or customers of the valuation object. The development of companies often depends on the development of the industry. If fewer cars are sold, this will not only have an impact on car dealerships, but also on automotive     suppliers.
  • Across industries: Which companies in other or extended industries have a similar business model? Manufacturers of sporting goods compared with manufacturers of other leisure products. Operators of airports compared with operators of train stations or ports. The search can also be conducted from the perspective of the customer or consumer: Which products are used together with the products of the valuation object? Which products are alternatives to the product?

The more specialized the activity of the valuation object, the more important the valuer's analysis and economic appraiser become.

Wrapping It Up

In many cases, DCF or Income approaches are necessary, even if these are considered difficult for SMEs due to the lack of listed peer companies needed to determine the beta factors. The application of intelligent search strategies and the use of special databases make it possible to prepare valuations using the DCF or Income approach.

FAQs

What are the main methods used to evaluate SMEs?
Can simplified pricing methods replace the DCF and Income approach?
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