Many SMEs Worth Half Their Owners’ Expectations

Although sterling now seems to have stabilised, this theme of increased interest from overseas companies is one that we do expect to continue in 2017

How would you react if you found out that you had been valuing your property at twice the price anyone was willing to pay for it? It’s unlikely to happen if you keep a close eye on the selling prices of similar homes in your area, but if you were to assume a three-bedroom house in the Highlands would sell for the same price as a similar property in Mayfair, you might be in for a shock.

The same is true in business valuation, although owners are much less likely to have access to data on valuations of similar firms.

There is a wealth of reasons that the owner of an SME would want to know what their business is worth: sale of enterprise, shareholder dispute, divorce or even probate, or simply to ascertain better the position of their company.

Until a valuation is carried out by a team of qualified accountants, no business owner can be sure what their company is worth. They may be tempted to estimate the value of their firm using an index such as the BDO Private Company Price Index, which shows the average Enterprise Value to EBITDA (EV/EBITDA) ratios of larger businesses, whose financials are publicly available.

EV/EBITDA relates the market value of a business to its Earnings Before Interest, Tax, Depreciation and Amortisation – a more comprehensive measure than price to earnings (P/E).

The BDO’s most recent data shows an EV/EBITDA ratio of 10.0. By this measure, an SME owner with annual profits of £1million might assume that their business could be sold for £10million.

However, new data from the UK200Group shows that indices such as the BDO Private Company Price Index may lead the owners of small businesses to over-value their enterprises.

The UK200Group has a unique position in the marketplace in that its members provide accountancy and law services to over 150,000 SME clients. Because of this, the organisation has access to more valuation data relating to the smaller end of the market – with a majority of companies valued at less than £25million – than any other in the UK.

The UK200Group has compiled the SME Valuation Index, a set of data that shows that the mean EV/EBITDA ratio of a smaller company valued by its members was 5.6million in 2016, as shown below:

Year - Mean EV/EBITDA ratio - Mean P/E ratio - Average deal size (£ million)
2016 - 5.6 - 8.1 - 5.7
2015 - 6.1 - 9.6 - 4.2
2014 - 5.1 - 7.3 - 4.4

By this measure, the SME owner whose profits are £1million should revise their valuation figure to £5.6million. This discrepancy of £4.4million could be significant to exit plans, business strategy and investment.

Simon Blake, Chairman of the UK200Group’s Corporate Finance Panel, explains the factors that mean small businesses have lower EV/EBITDA ratios: “Small businesses behave differently to large ones in a number of ways, so it is not simply a case of scaling up or down.

“In smaller companies, there is a greater level of entrepreneurial impact on the data that is used to create a valuation. Small business owners may put costs through the business that a large corporate would not. For example, at a firm I have valued the owner was taking his senior management on trips around Europe to celebrate business achievements. Those costs would not be incurred in a larger corporate firm in a similar industry. Because they are non-recurring costs and are unusual, these trips have taken £50,000 off the firm’s annual profits, potentially reducing the valuation of the business based on the 10x multiple above by £500,000 erroneously.

“Another consideration is funding. A typical bank will lend around 2 to 2.5 times EBITDA, at typically 50 or 60% loan-to-value. Because of this, the EV/EBITDA ratio of smaller firms will remain at 5 or 6. Larger businesses are able to command greater debt leverage and therefore greater debt funding.”

But has Brexit affected valuations in the SME community? Simon Blake says, “I think that it’s too early to say. The SME Valuation Index uses only valuations stemming from real transactions, which can take many months to go through. The 2016 figures are unlikely to include many deals that were first tabled after the referendum in June.

“My experience of 2016 is that we saw plenty of strategic buyers coming from places such as the US, paying a little more – in sterling – than they would have because of the depreciation of sterling against the dollar.

“Although sterling now seems to have stabilised, this theme of increased interest from overseas companies is one that we do expect to continue in 2017.”

What can business owners do to increase their Enterprise Value to EBITDA ratio?

“A key factor in a company’s EV/EBITDA ratio is the strength of its income stream, and I’ll use Microsoft as an example. Until recently, we would buy the Office package from Microsoft every few years for a one-off payment of £400, but now, we buy into the Office 365 package for an £80 subscription every year by direct debit.

“Microsoft has created a much more strongly-recurring, sticky revenue, which makes it much more valuable than a company that can’t predict its orders and takes orders for February in January but doesn’t know what it’ll sell in March.

“Companies with a subscription-based income have a much higher Enterprise Value to EBITDA ratio, so tech companies often have much higher multiples than, say, a retail business which is solely reliant on its brand to pull in customers.”

The SME Valuation Index was created by the UK200Group’s Corporate Finance Panel, and was compiled in 2016 by Daniel Shear of BKL Accountants. Simon Blake heads up the UK200Group’s 14-strong Corporate Finance Panel, and is also Partner and Head of the Strategic Corporate Finance Team at Price Bailey, a top 30 accountancy and business advisory firm.

The UK200Group, established in 1986, represents a significant group of trusted, quality-assured business advisers – chartered accountants and lawyers – who have over 150,000 SME clients in total. As such, the UK200Group acts as the voice for 1,899 charities, 3,887 farms, over 12% of all registered academies, 800 healthcare businesses and over 4,000 property and construction professionals.

ENDS

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About the UK200Group:

The UK200Group was formed in 1986, and is the UK’s leading association of independent chartered accountancy and law firms, with connections around the world.

The association brings together around 150 member offices in the UK with more than 500 partners who serve roughly 150,000 business clients. Its international links in nearly 70 countries give its members access to expertise across the globe.