Valuation snakes and ladders
Article Date: Apr 01 2004Take two companies. Equal size, equal prospects. Yet one is valued twice as highly as the other. Why? And how do you ensure your company gets the highest valuation possible?
If you really want to hitch a ride on the PLC gravy train to success and expansion you’ll need to value your business according to the rules of the market, not according to your own ego and greed.
Get the valuation issue right and you’ll win important, long-term business supporters to help your venture thrive. Get it wrong and a pandora’s box of intractable issues will open up to smother all your grandiose public plans.
It’s an art, not a science
From the outset, the whole valuation process hinges on hitting a price that leaves enough upside for the market in the weeks and months that follow your float, and one that simultaneously does not leave you – the owner and founder – sadly short-changed.
Unfortunately, arriving at the right price for your business is ‘an art not a
science’. So argues Adam Hart of broker KBC Peel Hunt, a firm that has floated countless companies and which most recently brought entrepreneur David Massie’s investment hopeful Meon Capital successfully to AIM.
A tale of two floats
Hart’s comment has particular resonance in light of the flotation fortunes
of two of the markets most recent floats – Clapham House and James Hull Associates.
When David Page, celebrated former director of Pizza Express, wanted to float shell company Clapham House on AIM last November to acquire other restaurant operators, his broker Noble had no trouble raising the £14.25 million he wanted at £1 a share. The subsequent price rise has added nearly 30 per cent to the value of the company, taking it to £19.5 million, and Clapham House has been able to make its first acquisition, of the Real Greek restaurant group, for up to £9.1 million in staged, performance-related payments.
Contrast, James Hull, founder of fast-growing James Hull Associates, which he built in 16 years to be Britain’s largest chain of dental practices, recently met a distinctly tepid response from institutions to a mooted £25 million float, to have been handled by broker Numis. This would have valued the company at £150 million, but he went back to the drawing board with a view to a potentially more modest flotation, with a price tag nearer £100 million, a third less than the original valuation.
Study your peers
The stock market values most companies on a multiple of their past and prospective profits and earnings. Other ratios are also used, such as the float price in relation to the company’s cash flow or its annual sales.
In the heady dotcom boom days, companies floating in fancied sectors would command multiples of hoped-for future turnover (often because they had none at the time). In sectors such as property or natural resources, assets and potential asset growth are the key factors.
The greater the ‘visibility’ or predictability of your company’s earnings, the greater the multiple. But, says Hart, a company coming new to the market must usually accept ‘a small discount to its already-quoted peers in the same sector’.
If you have no comparable quoted peers, your advisers may have to look further afield to find companies with similar patterns of growth and cyclicality. ‘You start with a ten per cent discount,’ suggests Hart, ‘and then you put in an uplift for any positive factors, such as faster-than-average growth prospects, better management or a different market.
‘Look at the sector average and then tweak it to allow for your company’s particular strengths and weaknesses. It is very unusual for a company to be able to float if it is seen to be significantly worse than companies already on the market’.
Institutions and other investors are likely to pay more if key existing owners are substantially ‘locked in’ and have undertaken not to sell most of their shares for a significant time. ‘Bosses selling out can be negative,’ warns Hart, and so can a float which is going to leave a high percentage of the shares in the hands of small shareholders, who will be likely to drip them out onto the market over time, continually depressing the price.
John East, whose entrepreneurial broking firm of the same name has been preparing healthcare clinic developer Eyebright for a £5 million AIM float, argues companies may have to accept discounts of up to 20 per cent to their already quoted peers. To minimise or even eliminate this discount, says Hart, ‘you must have an edge on the existing quoted companies in your sector’ or, even better, be unique, with no quoted rival, or with some unique technology.
There are, needless to say, exceptions to this rule. Meon Capital had no track record, but achieved a £4 million market value on the strength of its board, its backers and its business plan.
At the right point in the stock market cycle, entrepreneurs with established money-making track records can successfully float shell companies or new companies on their personal track records and future plans. David Page is a case in point, as is the Jim and Mark Slater father-and-son duo (currently performing in the gold sector with AIM-listed Galahad).
Calling the market
Both relative and absolute valuations will depend not only on the market’s analysis of your business, but also of your sector. Both will in turn depend on where the stock market cycle is when you want to float: timing is crucial for extracting the maximum value.
‘Spotlight on AIM’, a recently published research report by Growth Company Investor, and sponsored by solicitor Lawrence Graham, showed how wide the differences are in price-to-sales ratios. Forbidden Technologies, for example, a loss-making video technology hopeful, was valued at 4,000 times its negligible turnover, while Streetnames, a shell linked to noted investors Nick Leslau and Nigel Wray was trading at nearly 2,000 times turnover.
At the other end of the scale, beleaguered abrasives group Carbo was valued at less than a fiftieth of turnover, as was loss-making leather goods distributor Hartstone. Price/earnings ratios and dividend yields also show big differences between sectors.
Of the companies quoted in the Financial Times, the average multiple for the IT sector is 80 and the dividend yield 0.9 per cent. Media companies command an average p/e ratio of 36.8 and yield 1.7 per cent, while construction companies are valued at only ten times earnings and yield 3.26 per cent and life insurers are rated at 14.26 times earnings and yield four per cent. Absolute values can also change dramatically. The stock market virtually halved in the last bear market and the ratings accorded to different sectors can change, too.
‘There can be a 20 to 30 per cent difference between floating into a good market and a bad market,’ suggests Hart, and some would put it higher. Raging bull markets will take almost anything and arctic bear markets can be impossible to tap.
Investors need profits
Chilton Taylor at accountant Baker Tilly, who advised on Clapham House and is currently preparing several floats, says that, once the directors of a float candidate have formed their own view on its value, they must beware of accepting a ’flattering’ estimate from brokers. He contends that trying to extract the last farthing can either frustrate a float altogether or make it hard to come back for another financing later on. This is because the shares were so fully-priced on flotation, investors have made no money out of them.
‘Directors should be concerned about the after-market,’ he insists. If the float price leaves room for further increases, investors will be more inclined to support the company if it later wants equity funding for an important deal.
Hart reinforces this view. ‘Some owners go to the market insisting their business merits a p/e ratio of 15, though they know it is really only worth 12.
‘The highest price is not always the best price,’ he insists. ‘It is important not to take the last penny off the table.
‘You should allow a 10-to-15 per cent up-tick in the first three weeks if you want to come back for more.’ On the other hand, ‘a 100 per cent up-tick in that time would be bad and most brokers would shy away from such a company.’
Some might dismiss this as advisers’ and brokers’ special pleading. But an issue so priced as to leave no scope for some short-term appreciation is hardly going to attract the punters.
Taking a longer-term view, ‘Spotlight on AIM’ revealed widely differing share price performances last year by companies in different sectors which had newly come to the market. BioProgress, supporter of biotech projects, rose 313 per cent, video technology specialist Motion Media gained 300 per cent and computer educational hopeful ThirdForce gained 200 per cent.
Many business owners might say that was giving too much away to the market. However, if they have retained a significant stake, it will have benefited them and their companies’ future fundraising chances.
Those rises contrast with more modest gains of between 25 and 31 per cent chalked up by Alliance Pharma, Sinclair Pharma and Napier Brown Foods. These imply a closer correlation between the company’s own float valuation and the market’s.
Mark Fecher of accountant Kingston Smith’s Devonshire Capital arm says their recent survey showed 70 per cent of business owners confident they knew the value of their companies. But he has found that many instead look at what they are taking out of their private businesses in various ways and how they can maintain that after selling in a float — though the security of cash in the bank should justify a discount.
Test the water
One way of setting a value for your company which stock market investors are more likely to wear is to do some ‘pre-float’ marketing, for what Hart calls ‘a sanity check. If key investors say, “yes, we’ll take it at that price,” they might get a preferential allocation.’
Taking this idea further and raising funds from a few friendly investors ahead of the float — at a discount — is ‘becoming an increasing trend’, according to East, who is handling several ‘pre-IPO fundings’ at present. Venture capital trusts and others could be willing to put in money between six months to a year before the float, but they are likely to expect to be able to buy on multiples ranging between a half and a quarter of the eventual float ratings.
Pre-float funding at considerably below the float price was a notable feature of Russian prospector Highland Gold Mines’ AIM float. If the price difference is too great, it can pit float subscribers against pre-float subscribers.
Pre-float money can enable your company to do the deals it needs to do to make it floatable — East recalls how a shareholder of a mobile phone concern put in £17 million to enable it to do software licensing deals that were seen as crucial to its flotation prospects. If, however, heavily discounted pre-float funding is seen as simply a means of giving friends and family a locked-in instant profit, it will do no good to your company’s reputation or stock market potential.
