Concentrations are a significant issue in valuing a business enterprise. The presence and magnitude (or absence) of business concentrations are major considerations in assessing a subject company’s risk profile and financial outlook. Other things being equal, the presence of significant concentrations frequently results in a lower value than otherwise might be expected because the appraiser considers it necessary to apply a higher discount rate or required return, a lower forecast of future earnings, a lower expected earnings growth rate, and/or a lower capitalization factor (earnings or cash flow multiple) in developing his opinion of value.
The term “business concentrations” covers a variety of situations, including a company dependent on:
Concentrations have two detrimental impacts on the company’s value. First, concentrations tend to imply a risk of a decline in revenues due to an interruption of the company’s ability to deliver its products or a decline in the demand for its products. Second, they may imply limits on revenue growth through potential market saturation or through limits on the company’s productive capacity.
Risk of lost revenues, and hence, of reduced earnings or cash flow, typically leads the appraiser to determine that a higher return is required on an investment in the subject company. The increased return requirement results in a higher earnings capitalization factor (expressed as the required return minus expected earnings growth) and, in turn, in a lower capitalization factor (the reciprocal of one divided by the percentage capitalization rate). In the direct capitalization of earnings approach to valuation, value is defined as the product of expected earning power and the capitalization factor where value declines with the factor. Similarly, if the appraiser employs a discounted future benefits methodology with a specific forecast of earnings or cash flow in his appraisal, the higher required return implies the application of a higher discount rate, and hence, a lower net present value for the company’s earnings stream.
Limits on growth implied by concentrations lead the appraiser to determine that a higher capitalization rate (the required return minus the growth rate) and therefore, a lower capitalization factor (one divided by the capitalization rate) is appropriate. Value, as the product of the capitalization factor and earning power, thus declines. Where a specific forecast of earnings is used, the forecast of lower future earnings stream results in a lower net present value. In some cases the concentrations may imply both a higher risk profile and constraints on growth, negatively affecting all of the key valuation assumptions.
In some cases, the negative implications for value of business concentrations may be substantially or even entirely mitigated by the presence of long-term contractual agreements binding customers and suppliers to the company.
In preparing any valuation analysis it is essential that the appraiser identify any and all relevant business concentrations, assess their magnitude, recognize any mitigating factors, and reflect the impact of the concentrations in the valuation by adjusting the discount rate, capitalization factor, earnings forecast, or some combination thereof in a logical, measured manner.