Many situations warrant an business appraisal / valuation. Some of the most common occurrences in which a business will need to conduct a valuation include litigation matters, preparation for the sale of a business, tax purposes, buyouts of financial stakeholders, financial reporting of acquired businesses and the issuance of a business-related insurance policy.
Furthermore, conducting a business valuation takes energy and time, and should be conducted by an independent valuation specialist. Selecting a valuation specialist / business appraiser can be complex, which we discussed in a another article, "How to Choose the Best Business Appraiser."
When beginning the process of a business valuation, a clear understanding of the owner’s bundle of rights is critical before any investigative and analytical procedures are started. After a clear scope is outlined, the analysis is ready to commence. We conceptualize the value principles of most operating businesses into three components: (1) Risk, (2) Growth and (3) Earnings. We believe these are key components of value in a business. Using these as a guide, we seek to understand the nature, history and operations of a business through the perspective and intimacy of the team operating the assets every day, management. To do so, we find it helpful to discuss the operations in the same way as management thinks about its business. We strive to understand the risks that management wants to minimize the growth opportunities that management wants to obtain and the earnings that provide the scorecard for historical operations. The following details the factors which impact these three key components of value in a business.
Risk
Risk is the measurable possibility of something happening or not happening.1 For businesses, risk can be measured in numerous ways including benchmarking against similar businesses (“guideline”) or using a more theoretical approach such as a buildup method from market observation. None of this can be done, reasonably and supportably, without understanding the key economic drivers of the business. This prerequisite entails understanding the historical and current operations, the industry and competitive environment, operating assets, liabilities (booked and/or contingent), stakeholders, growth factors and the earnings profile of the business going forward. After understanding the drivers of risk for the subject business, the same drivers may be ascertained for the guideline businesses so that a supportable comparison can be made, ideally. However, lack of publicly available information does not make this comparison simple, and professional judgment is involved. Rarely is an exact "replica" of a business found in a guideline sample. With an appropriate understanding of the risk factors, and its comparison to similar businesses, the resulting value of a business begins to form. All other factors equal, low risk translates to higher valuation and vice versa.
Growth
Business growth is primarily discussed in the context of revenues, profits, cash flows and assets. For some companies it also can include number of locations, products, contracts, square feet, customers and employees. In addition, growth on a larger, macro scale must also be considered as it applies to economies, industries, markets and populations. These areas are an example of the growth factors which can significantly impact a valuation and careful attention must be made to fully understand these factors in context. When we investigate the nature and history of the business, we find a relative context for future growth. Many times management and business owners make decisions to enhance shareholder value, which may include attaining the highest valuation possible. These decisions are most transparent in forecasts and projections. Risk is inter-related to future growth expectations. In short, considering growth in the context of risk is critical during a business appraisal. All other factors being equal, high growth translates into higher valuations and vice versa.
Earnings
Earnings are naturally a key component to analyze and arguably the most important of the three. Earnings, in this context, is a broad term to discuss operating performance of a business and is inclusive of such terms as EBITDA, net income, dividends, distributions and cash flow, to name a few. Earnings are the primary financial benefit of owning a business and are indications of performance. Careful consideration of these metrics, including industry specific earnings metrics, is very important. Changes in theses metrics over time can provide clarity on operational problems and successes. In addition, appraisers may also consider the earnings of other guideline businesses in the industry. Benchmarking may provide conclusive support regarding industry specific issues in the business but also macro issues across the economy. Earnings have significant impact on businesses strategy, future investment and capital decisions. Without investigating the earnings of a business, an appraiser cannot make an informed opinion on the value of a business.
Summary
All these components can vary substantially as time passes. An appraiser cannot simply assume that growth and earnings will continue uninterrupted into perpetuity. A marketplace is organic and can change quickly. When this occurs, growth over the long term can be difficult to achieve, and people may underestimate the risk associated with high long term growth projections. Careful analysis is necessary when estimating terminal values at the end of a long term growth forecast. When it comes down to valuing a business, understanding risk, growth and earnings are paramount.
This article was originally published in Valuation Viewpoint, November 2014.
