Licensed Financial Services Provider
EXTRACT TAKEN FROM:
Premiums &
Problems
Edition No. 113
July 2016
Open Rubric
Business Assurance Extract
Premiums and Problems Edition 113
Business Assurance
Valuing Business Interests
1. Introduction
Placing the correct value on a business is a difficult and involved exercise. Various methods,
assumptions and techniques can be used as well as numerous adjustments to the underlying cash
flows, income statement and balance sheet items before a reasonable valuation can be reached.
It is expected to have different valuation results given by different valuators, advisors and
underwriters, potentially leading to confusion and disagreements.
This section aims to reduce and ultimately limit any potential disagreements by discussing the basic
principles underlying the valuation of a business, plus going into some detail on the different valuation
methods and assumptions used in the market.
Please note that these are guidelines and great care is required when valuing a business. They need
to be interpreted in line with the specifics of the business being valued. In no way can these principles
be applied without serious consideration of the specific situation being analysed.
2. Assumptions used in business valuations
The assumptions used when valuing a business are of critical importance and can significantly affect
the final valuation result.
Particularly important is the fair rate of return used in the business valuation. The fair rate of return is
the annual return an investor should expect to receive should the capital be invested in a reasonable
similar business in the same industry. A reasonable rate of return would range between 10% and 20%
depending on the business historical performance. It is thus important to assess the “riskiness” and
“track record” of the business being valued and to adjust the assumptions accordingly.
3. Valuation methods
The methods used to value a business entity could vary depending on the purpose of the valuation.
The following four valuation methods should be viewed from a life insurance business cover
perspective.
For example buy and sell valuations are different from contingent liability. When assessing buy and
sell cover, we need to establish the respective entity’s worth from either a net assets or an income
generating ability point of view. This then differs with the issue of contingent liability cover, as some of
the new established business entities will probably run with a negative net asset value due to the
outstanding loans and other liabilities. It is therefore essential to establish whether the business entity
can still service the loans, meet its financial obligations (including expected premium payments of
the proposed life insurance business policies) and stay profitable.
Some underwriting challenges include:
 Inflated values; and
 Deciding on whether the assumptions are optimistic or pessimistic.
The basic assumption is that the value will change over time. An upward trend is always welcomed
as opposed to a downward trend. There is always a wide gap between projections and reality.
3.1. Intrinsic Value Method
This method is particularly applicable to investment and property businesses, because the values
of these businesses are mainly in the assets. The intrinsic value method values the business as the
difference between the assets and liabilities; it is also called the “net asset value” method.
Business Assurance Extract
Premiums and Problems Edition 113
Steps:
(a) Establish the total value of the assets at an acceptable market value.
(b) Establish the total liabilities.
(c) Deduct the liabilities from the market value of the assets.
Step (c) gives the intrinsic value of the business.
To calculate the value of a particular individual’s share in the business, multiply the Intrinsic Value
by the percentage of the individual’s interest.
Example:
Assets
R8 700 000
Fixed assets
Current assets
R6 200 000
R2 500 000
Liabilities
R3 700 000
Long-term liabilities
Current liabilities
R2 500 000
R1 200 000
Intrinsic Value
R5 000 000
If there are three partners, namely A, B and C, with ownership percentages of 35%, 40% and 25%
respectively, their individual interest in the business would be:
A: 35% x R5 000 000 = R1 750 000
B: 40% x R5 000 000 = R2 000 000
C: 25% x R5 000 000 = R1 250 000
Advantages of using the Intrinsic Value Method:
 This method can be used if the business entity’s value is demonstrated mainly in its assets.
 The calculations are easy as the figures are taken directly from the balance sheet.
Disadvantages of using the Intrinsic Value Method:
 This method does not take any future growth in the business into account.
 On some occasions the book value is far below the real market value.
 There are no guidelines for establishing the market value of assets unless you involve a valuation
expert.
 It is hardly used in the first 5 years of the life of a business entity, as a result of the small expected
net asset value due to the loan accounts and accumulation of other liabilities.
3.2. Earnings Yield Method
This method is applicable where the asset base is not directly related to the earning potential of the
business, for example a business that provides professional services or a trading business.
The actual value is derived from the net earned income after tax generated from the services
delivered.
Business Assurance Extract
Premiums and Problems Edition 113
Steps:
a. Establish the expected future annual net income after tax:
aa. The current net income after tax can be taken straight from the income statement.
bb. Multiply this figure by an appropriate annual increase factor to calculate the future
expected net income after tax.
b. Establish a reasonable fair rate of return.
c. Capitalise the annual future net income at the fair rate of return.
Example:
Current annual net income after tax
R1 500 000
Expected annual growth factor
10%
Expected future net income after tax
R1 500 000 + (R1 500 000 X 10%)
R1 650 000
Fair rate of return
15%
(Assuming a well-established business)
Earning yield value
R1 650 000 ÷ 15%
R11 000 000
Notes:
 It is important to consider the net earnings in detail.
 Once off amounts, such as exceptional profits, or major expense outlays, can impact the net
income of the business in a particular year, and should sometimes be excluded.
 This is a complicated area and care must be taken to only adjust the income where really
deemed appropriate.
It is recommended that the income used should be net of all expenses and tax.
Advantages of using the Earnings Yield Method:
 This is a forward looking method and values the future net income streams of the business. It is a
good method because it is based on the present value of the expected future income. Therefore
it provides the assessor with an idea of the possible future earnings of the business entity assuming
optimal or steady economic growth.
 This method is most applicable where the asset base is not directly related to the earning
potential of the company, e.g. services companies.
 It is widely used in the insurance industry.
Disadvantages of using the Earnings Yield Method:
 Care must be taken when considering the appropriate fair rate of return.
 This method ignores the capital employed in the business.
 It treats the profits as ceaseless.
Business Assurance Extract
Premiums and Problems Edition 113
3.3. Dividend Yield Method
This method is applicable when valuing minority shares in a larger established business that provides
a steady stream of dividend income.
Steps:
(a) Establish the future dividend declaration. This can be calculated from the current dividend
declaration.
(b) Multiply the current dividend declaration by an appropriate annual increase factor to calculate
next year’s dividend declaration.
(c) Establish a fair rate of return.
(d) Capitalise the annual future dividend declaration.
(e) Multiply this capitalised value by the number of shares held.
Example:
Annual dividend per share
Expected annual growth
R45
10%
Expected future dividend declaration
R45 + (10% x R45)
Fair rate of return
R49.50
15%
(Assuming a well-established business)
Capitalised value of each dividend
R49.50 ÷ 15%
R330
Assuming 1000 shares held
Dividends yield value 1000 X R330
R330 000
Advantages of using the Dividend Yield Method:
 Most suitable when valuing shares related to a small percentage shareholding in a business
entity.
Disadvantages of using the Dividend Yield Method:
 Seldom used in the insurance industry;
 Ignores the assets value.
The assessor should consider the historical performance of the dividends over a sufficient period of
time before starting the calculations
3.4. Super Profits Method
The super profits method is essentially a combination of the intrinsic value method and the earnings
yield method. It thus takes the asset value as well as the future expected income of the business
into account with the intention of arriving at a business value.
It is an appropriate method to use where the value of the business is contained in its assets as well
as in its future earning potential.
Business Assurance Extract
Premiums and Problems Edition 113
The super profits method takes into account the present value of the future expected earnings,
assuming a reasonable fair rate of return is used.
These “super” earnings or profits are then capitalised over a predetermined period, during which
the business is reasonably expected to maintain this high level of return on investment. A five-year
period is commonly used for the purpose of this time value of money calculation.
Once the present value of the super profits during the proposed five-year period has been
calculated, the net asset value of the business is added to arrive at the total business value.
Steps:
(a) Establish the net assets employed in the business after deducting liabilities i.e. establish the
intrinsic or net asset value.
(b) Determine the annual expected income after tax. These allow for the super profits expected.
(c) Determine a reasonable fair rate of return and the number of years over which super profits are
expected e.g. 5 years.
(d) Calculate what is considered as fair income i.e. the assets employed X a reasonable fair rate of
return.
(e) Calculate the super profits i.e. the projected income – the calculated fair income.
(f) Calculate the discounted value of super profits over a number of years by using the
assumptions.
(g) Calculate the final value of the business = value of assets (Step a) + discounted value of super
profits (Step f).
Example:
Total capital employed
R5 000 000
Total net assets
R4 000 000
Expected annual income per year
from this capital
(Expected annual income
estimated for the next five years)
Fair rate of return
(low risk investment)
Projected income from
capital employed
R5 000 000 X 15%
R850 000
15%
R750 000
Super profits per year
(Expected annual income –
projected income from capital)
R850 000 – R750 000
Discounted value of super profits
at 15% over 5 years to present
value.
R100 000 x 3.35
Total value of the business
R100 000
R335 000
(Total net assets + the discounted
value of super profits)
R4 000 000 + R335 000
R4 335 000
Business Assurance Extract
Premiums and Problems Edition 113
Advantages of using the Super Profits Method:
 This method is the most suited for valuing a majority holding in a business entity.
 It takes both asset value as well as expected income into account, offering a fair approach to
the valuation.
Disadvantages of using the Super Profits Method:
 It is a complicated method and care needs to be taken when it is used.
 The results can be easily influenced by changing the assumption.
 It can be used to enhance the business valuation but often either the intrinsic or earnings yield
methods are broadly preferred in the life assurance industry.