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.
*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/