Businesses face uncertain conditions today, including geopolitical and cybersecurity risks, inflation concerns, environmental issues, and a lack of clarity about future tax laws and interest rates. Here’s an overview of how business valuation professionals factor these kinds of issues into their value conclusions.
Market analysis
Before crunching the numbers, valuators must fully understand the market conditions in which the subject company currently operates. This involves evaluating macroeconomic indicators (such as growth in gross domestic production, inflation rates, interest rates and unemployment levels) and industry-specific factors (such as market trends, competitive landscape and regulatory changes).
Analytical procedures may need to be more robust during times of market volatility. Valuators can’t presume that the subject company will maintain the status quo in uncertain markets. Moreover, some industries may be more susceptible to market volatility than others.
It’s important to analyze the subject company’s resiliency to past market changes. Key factors include the strength of its balance sheet, the diversity of its revenue base, its operational flexibility and its ability to innovate. Resilient businesses usually command higher selling prices than weaker competitors, even in uncertain market conditions.
Cash flow forecasts
When using the income approach, business valuation experts may rely on management’s cash flow forecasts or create independent forecasts based on the company’s historical results. In uncertain market conditions, valuators may adjust historic cash flow to reflect less optimistic expectations for revenue and costs in future periods.
Sometimes valuators forecast multiple scenarios (such as best-case, worst-case and most likely scenarios) to capture a range of potential outcomes. Sensitivity analysis can also be useful for understanding how changes in key assumptions, such as revenue growth rates or cost structures, affect the business’s value.
Discount rates
Under the income approach, valuators use risk-based discount (and capitalization) rates to estimate the present value of expected future cash flow. A discount rate is usually based on the subject company’s cost of capital; this rate is used in the discounted cash flow (DCF) method. A capitalization rate equals the discount rate minus the long-term sustainable growth rate; the capitalization rate is used in the capitalization of earnings method.
Economic uncertainty is an important factor to consider when quantifying discount rates. For example, valuators may consider market volatility when deciding on the appropriate risk-free rate, equity risk premium and company-specific risk to use to build up the cost of equity.
Market conditions also may impact the capital structure (the percentage of debt vs. equity capital) to use if the discount rate is based on the weighted average cost of capital. When debt financing is scarce, some companies might have to finance future growth internally, rather than with loans, thus altering their historic blend of debt and equity.
Pricing multiples
Pricing multiples are used to determine business value under the market approach. They’re calculated by comparing the sales prices from guideline transactions or public stocks to financial metrics from comparable companies’ financial statements. Examples include price-to-cash flow and price-to-revenue multiples.
In times of economic uncertainty, valuators may adjust median or average pricing multiples from comparables to reflect expected risks going forward. Adjustments are especially important if there are differences between the valuation date and the dates of guideline transactions. A valuation is valid for a specific point in time, and changes in market conditions over time can significantly affect value.
Valuation techniques
Preferred valuation methods may also depend on market conditions on the valuation date. For instance, if conditions are expected to be disrupted only temporarily, a valuator might decide to use the DCF method, rather than the capitalization of earnings method (which is based on cash flow for a single representative period).
Under the DCF method, future cash flows are forecast over a discrete period and then discounted to present value using a risk-based discount rate. After the disruption period, normalized cash flow for a single period is forecast, and the capitalization of earnings method is used to calculate terminal value. This methodology allows the valuator to vary the company’s expected cash flow and/or the discount rate over the period of the disruption.
Valuation discounts
When experts use the income or market approach to value a business, they typically arrive at a fully marketable, cash-equivalent value. A percentage discount may need to be taken from the preliminary value to reflect the time, costs and uncertainty of selling a business interest. This is called a discount for lack of marketability. The term “marketability” refers to how quickly an investor can convert property to cash at minimal cost and for a relatively certain price.
Customarily, this discount is taken when valuing minority (noncontrolling) interests. A discount also may apply when valuing controlling interests because such interests can’t be sold and liquidated immediately. This is usually referred to as an “illiquidity” discount.
The appropriate discount depends on a variety of factors, including market volatility. Higher expected volatility may translate to a higher discount for lack of marketability.
Warning: Don’t double count
Uncertainty generally increases business risk, which equates to lower value. But it’s important not to double count these factors when estimating the value of a business interest. Double dipping (for example, by lowering expected cash flow and reducing the cost of capital) can lead to unreasonably low value conclusions. Our experienced valuation pros understand this pitfall. Contact us to determine what’s appropriate for your situation.
© 2024
