For South African business owners, the economic stability of Europe coupled with business-friendly legislation makes the continent a desirable place for expansion. While these factors are attractive, access to financing and the potential for lucrative upside when exiting a business are the real drawcards.

We recently performed a valuation exercise for a client who intends to swap shares in a successful South African application software company for those of a similar company in the Netherlands. While these companies operate in the same industry, we found the comparative valuations to be vastly different.

The 3 factors that had the greatest impact on the valuation – the ” triple edge sword” –  were the valuation multiples, the cost of debt, and the cost of equity.

Valuation Multiples

When we perform valuations, we use search parameters to screen hundreds of companies within a comparable industry and/or geographic region. Through this process, we derive a range of companies deemed comparable to our subject. Without regard to a specific industry, we found that the median EV/EBITDA multiple (i.e. the value of a company over its earnings) of selected listed companies in the Netherlands was just under 12x, whereas in South Africa, the multiple was just over 6x. Assuming that our South African and Netherlands companies achieve the same currency-adjusted EBITDA, our South African company takes a valuation hit of about 50% before we even consider the cost of capital for the business.

A report compiled by the CAIA Association echoes our findings, stating that EBITDA multiples in Europe during 2020 approached 12.6x, while in Africa, multiples were between 4x and 8x.

Cost of Debt

The CAIA Association also alludes to the second edge of the sword –the cost of debt – suggesting that higher valuations are likely a result of prolonged quantitative easing and low-interest rates in developed countries. Access to debt at low-interest rates benefits a business from a valuation perspective, as the weighted average cost of capital (“ WACC” ) used to discount the company’s cash flows is lower (lower discount = higher value). The OECD reports that SMEs in the Netherlands have access to debt at an interest rate of 3.3% per annum, whereas we know from experience that an SME in South Africa will be lucky to service debt at less than 15% per annum. In our example below, if both companies were financed entirely by debt, a South African company would achieve a valuation of about 30% lower than a Netherlands comparable.

Cost of Equity

The third edge of the sword and the second component of WACC –the cost of equity – is essentially sharpened by the stark contrasts in the economic climate between Europe and South Africa. Using the capital asset pricing model (“ CAPM ”) to derive a cost of equity, our starting point is the “risk-free rate”. As mentioned, developed countries have benefited from a period of quantitative easing which sees the yield on 10-year government bonds (a proxy for the risk-free rate) in the Netherlands at 1.4% at the time of writing, versus a yield of just over 10% in South Africa. This makes South African bonds an attractive investment but greatly elevates the cost of equity which is detrimental to a South African company’s valuation.

The other levers for the CAPM formula are the market risk premium and “beta”. The latter measures how a company reacts to systematic market risk and is generally lower in developed markets vs emerging markets. Put simply, this means companies in developed markets are less exposed to downturns in the market. The measure is highly dependent on industry and would not be considered a main component of the differences in valuations between European and South African companies. Market risk premiums, however, can increase the discount rate considerably. A South African equity risk premium is circa 7%, versus circa 4% in the Netherlands, based on research done by Prof. Damodaran of NYU Stern. Interestingly, the combined difference in risk-free rate and market risk premium results in a South African company achieving a valuation that is again 30% lower than the Netherlands comparable (again, assuming all else equal).

There are, of course, many other factors to consider when performing a valuation; however, based on these 3 simple metrics alone, it is clear to see why South African business owners look outside of the country to unlock greater value for their companies.

References

CAIA Association. (2021). African Private Equity Returns, Risk and Potential in a Global Context – Part I | Portfolio for the Future . [online] Available at: https://caia.org/blog/2021/11/23/african-private-equity-returns-risk-and-potential-global-context-part-i   [Accessed 19 Aug. 2022].

OECDiLibrary. (n.d.). Financing SMEs and Entrepreneurs: An OECD Scoreboard (The Netherlands) . [online] Available at: https://www.oecd-ilibrary.org/sites/d339ecf2-en/index.html?itemId=/content/component/d339ecf2-en   [Accessed 19 Aug. 2022].

Tradingeconomics.com. (2022). South Africa Government Bond 10Y . [online] Available at: https://tradingeconomics.com/south-africa/government-bond-yield [Accessed 19 Aug. 2022].

Tradingeconomics.com. (2022). Netherlands Government Bond 10Y . [online] Available at: https://tradingeconomics.com/netherlands/government-bond-yield [Accessed 19 Aug. 2022].

Damodaran, A. (2021). Country Default Spreads and Risk Premiums . [online] Nyu.edu. Available at: https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html . [Accessed 19 Aug. 2022].

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When the ground starts to shake around Cape Canaveral, it is a matter of seconds before a rocket is launched and begins its journey into space. But leading up to this moment there have been months, if not years, of preparation and planning for every eventuality. Countless inputs are considered and risks mitigated by modelling various potential scenarios. Without these meticulous processes, a mission is destined for failure.

Like launching a rocket into space, a business needs a thought-out and refined plan to have any hope of lifting off. A key step in assessing the viability of a business plan is forecasting what could be achieved, taking into account as many factors as possible. Such factors include expected sales, customer types, product and service pricing, human resources, capital expenditure, and financing requirements.

How do we consider this plethora of factors effectively, you may ask? Enter the Financial Model.  A Financial Model, as the name suggests, seeks to model the potential performance of a business by combining relevant inputs and assumptions into a financial forecast. A Financial Model can be used as a budgeting tool, to stress-test different scenarios, to calculate the financial impact of a new project, to allocate corporate resources, and to determine the value of a company.

The first step in developing an effective Financial Model is to apprehend the environment in which a business operates and to identify inputs that will impact its performance. At Creative CFO, we have prepared Financial Models for companies like Wingu Academy, BancX, and Automata;  all three of which are exciting, high-growth companies, but operate in significantly different business environments.

For Wingu Academy , the inputs we considered include student enrolment numbers, subjects and classes per student, books per student, and the number of classes a teacher can manage. For BancX , we factored in banking certification costs, volumes of accounts and cards, interchange fees, interest rates, and platform fees. For Automata we needed to consider the manufacturing process for robots, including production capacity, supplier terms, shipping policies, customer warranties, and commission structures for their sales team. Because no two businesses are the same, the specific inputs to every Financial Model are unique.

Once the inputs for the Financial Model are determined, the second step is to consider how these inputs may change over time or how they may be influenced by different scenarios. Again, the way this step plays out is dependent on the specific business. For Wingu Academy , the scenarios we considered hinged on the number of enrolled students, for BancX the scenarios were driven by the number and type of customers that were onboarded, and for Automata the scenarios were driven by considering business performance for different levels of demand and stress-testing whether production could keep up with each scenario.

We develop a “low road”, or worst-case, scenario based on the premise that things don’t quite go according to plan (e.g. low student intake, low volume of accounts, or inefficient manufacturing processes). This gives the business owner an indication of the risk involved in embarking on the business journey. On the other end of the scale, we build out a “high road” scenario that portrays to business owners and investors the results that the company has the potential to achieve. Somewhere between these two extremes is the “middle road” scenario where we use more conservative estimates and assumptions for each of the required inputs. An effective Financial Model allows the user to toggle between every scenario with the click of a button.

Finally, we need to arrange the inputs into a format that allows business owners and investors to easily observe and evaluate the financial performance of a company over time. The format is known as the 3-Statement Model. It is a combination of an Income Statement, Balance Sheet, and Statement of Cash Flows. These three statements are presented on one page, allowing the user of the model to observe how income and expenses generate assets and liabilities and translate into cash for the business. The final line of the 3-Statement Model is typically Free Cash Flow to Equity (“FCFE”) – this figure is the cash that can be distributed to the shareholders of the company as dividends after all expenses, reinvestments, and debt repayments are taken care of. FCFE can also be altered into Free Cash Flow to the Firm (“FCFF”) by adjusting for debt. FCFF represents the cash flows available to both shareholders and lenders. Both of these figures are vital metrics that investors use to arrive at a Business Valuation.

A Financial Model is an essential step in making sure your business doesn’t get stuck on the launch pad. Get in touch with our investment team to ensure your business is ready for lift-off.

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In an office-based work environment, smart shoes are essential. However, as the recent pandemic has shifted meetings from board rooms to video calls the need for formal attire has become limited to clothing seen from the waist up. This, in turn, has caused the demand for comfortable shoes to climb through the roof, while the need for formal footwear, like stiletto heels, has dropped sharply – pun intended.

The German footwear brand, Birkenstock, was ready for this transition with their famously comfortable sandal. Birkenstocks are adored for their arch support and hipster appeal – hardly the purview of high-finance – but at least two private equity firms expressed an interest in buying the sandal manufacturer, which was valued at between € 4–4.5 billion*. L Catterton, the company behind fashion giant Louis Vuitton, finally won the bid, purchasing Birkenstock in February 2021**.

The purpose of a Business Valuation

While most can only dream of selling their business for that amount of money, it is important to know how one goes about valuing a business, no matter what the size. A valuation may be required for periodic reporting (i.e. feedback to investors), investment analysis, capital budgeting, raising capital, selling shares in the company, or selling the entire business, as is the case with Birkenstock.

Birkenstock is a well-established company (over 200 years old) and the valuation techniques used for this golden oldie are very different from what would have been used if the company was still in its infancy. Aligned with our vision at Creative CFO to create a world where more SMEs succeed, we will focus on explaining the valuation techniques that would be helpful for the “next Birkenstock”.

How do we value a business?

There are various methods of valuation that are acceptable in terms of the International Private Equity and Venture Capital Valuation (IPEV), and using two or more is considered best practice for valuing a company. This allows for the business to be seen from different perspectives, resulting in a more comprehensive and reliable view.

The methods we often use to value companies in the start-up and growth phase include two Discounted Cash Flow (DCF) methods, the Venture Capital (VC) method, and two qualitative methods:  the Scorecard Method and the Checklist Method. The DCF methods, which we will be describing in this article, represent the most well-known approach to company valuation. These methods are recommended by academics and are also used as a daily tool for investment analysts.

The DCF methods: The go-to guys

The two DCF methods are “DCF with LTG” (Long Term Growth) and “DCF with multiple”. Using these methods we attempt to derive the value of the company today based on projections of how much cash a business will generate in the future. From a technical perspective, we derive the present value of the projected cash flows that the company is forecasted to generate each year in the future by discounting these cash flows by a market risk rate. In essence, this takes into account the time value of money and reduces the cash flow each year – acknowledging that R100 in a few years’ time isn’t worth as much as R100 today.

In South Africa more than 70% of SMEs fail within their first 5 years. This means that it is extremely important to weight projected cash flows by the probability of an SME’s survival. In determining an appropriate risk rate, we consider risks related to the specific industry that the company operates in, the company’s size, stage of development, and the company’s perceived profitability.

Long Term Growth or a Multiple?

Once we have modelled the cash flow over a specific period by constructing a financial forecast , we need to assign a Terminal Value (TV) to the business. The TV represents potential future cash flow, beyond the projections we determined through the financial forecast.

To calculate the TV we use one of two DCF methods: DCF with LTG or DCF with multiple. DCF with LTG assumes cash flows will grow at a constant rate beyond our forecast, while DCF with multiple assumes the TV is the exit value (the price the investor receives upon sale) of the company which is computed by incorporating an industry-based multiple of EBITDA. The multiple is derived by taking into account the EBITDA average of recently acquired companies compared to their value (e.g. if Company X was sold for R10 million but has a TV of R800,000, the applied multiple would be 12.5).

Once we have calculated the projected cash flows and the TV of a specific business we apply an illiquidity discount to complete the valuation. Illiquidity (the opposite of liquidity) refers to how difficult it is to convert an asset into cash. The illiquidity discount is therefore built in to acknowledge that selling an SME (liquidating) is not as easy as selling a large, well-established company like Birkenstock.

The illiquidity discount essentially means that a big, Birkenstock-type company will be more expensive than a small anonymous one. Therefore there will be a more substantial discount for the buyer of the small company because it would be harder to exit (sell).

Using more than one method

Aligned with best practice, we use the other three methods mentioned above to derive a weighted average of the valuations. This leads us to our final valuation – how much we think the company is worth. The weights of each method are applied according to the stage of the business (i.e. idea stage, development stage, start-up stage, and growth stage). The DCF methods make up the majority of the weight once the company is in the start-up stage and beyond.

A Business Valuation requires consideration of a plethora of different factors and can be tricky to get right, especially for a company in the early stages of operations. Knowing the value of a concept or a business model is vital to upscaling into a world-class company.

At Creative CFO we love to see the SMEs of this world become the Birkenstocks. Get in touch and let us help you out with the first step.

References

*Birkenstock sold to LVMH-backed group in €4bn deal. The Financial Times. 26 Feb 2021. https://www.ft.com/content/5d511022-46db-403e-9784-eb3807f918f9

**Bain, Marc. The company behind Louis Vuitton is now backing Birkenstock. Quartz. 26 Feb 2021. https://qz.com/1977953/birkenstock-has-been-bought-by-a-lvmh-backed-private-equity-fund/

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