Wondering how the current economic situation affects business valuation? To gain an insight, let’s take a look at the fundamentals of business appraisal.
Three approaches to business valuation
The value of any business can be measured three ways, known as approaches:
- Market – by comparing the recent sales of similar businesses.
- Asset – by studying the costs associated with business creation.
- Income- by assessing the business earning capacity and risk.
Income-based business valuation – capturing the economic downturn effects
The income approach to valuing a business offers perhaps the best way to assess the effects of the economic ups and downs. The reason is this: all income-based business valuation methods are forward-looking.
Business value is affected by the earnings outlook
In other words, you can calculate your business value based on the business earnings forecast. Needless to say, the earnings outlook will be greatly influenced by macroeconomic factors.
Business valuation and increased risks
In tough economic times, business investment carries additional risk. Your income business valuation incorporates this in the form of discount and capitalization rates. The more uncertain the future, the higher the business risk and the associated discount and cap rates.
The build-up model for calculating the discount rate shows this effect very clearly. In particular, the risk-free return and equity risk premium reflect the macroeconomic environment – something every business is exposed to.
Industry sector risks
Your company’s risk also needs to be adjusted for the industry-wide factors. These affect all businesses operating in your industry. If the industry is vulnerable as a whole, the business is likely to be impacted as well. This increases the discount rate, lowering your business valuation.
Two key effects of economic downturn on business value
To summarize, an economic downturn is likely to affect your business valuation two ways:
- By lowering the expectation of business earnings.
- By more conservative business risk assessment – which leads to higher discount and cap rates.
Example – how economic downturn can reduce business value
We will use the well-known Discounted Cash Flow business valuation method. As is the case with most professional business appraisals, we use the business net cash flow as the earnings basis. The result is calculated as the Market Value of Invested Capital, the typical value measure in small business appraisals.
Our initial earnings forecast, created before the downturn took hold is as follows:
- First year: $250,000.
- Second year: $275,000.
- Third year: $290,000.
- Forth year: $310,000.
- Fifth year: $335,000.
The company is debt free and we have estimated the equity discount rate to be 25%.
Given the latest developments in the market, we have revised our cash flow projections as follows:
- Year 1: $200,000.
- Year 2: $210,000.
- Year 3: $245,000.
- Year 4: $290,000.
- Year 5: $330,000.
We further conclude that the additional risks have increased the discount rate to 32%.
Using the Discounted Cash Flow method for both scenarios, gives us the following business valuation results:
- Original figures: $1,440,231.
- Revised for economic downturn: $1,060,266.
In other words, the lower expectations of financial performance in the current market have reduced the value of the business by almost $400,000 or 40%!
Business valuations can increase in some market niches!
This, of course, is merely an example. A business can thrive in a down ecomony because it occupies a unique niche in its market.
Essential products such as food and energy continue to be in demand. If your house floods you will still need a plumber to fix the problem.
Businesses and consumers looking to save money may keep their old cars running longer. While the new car dealership may suffer, the auto repair shop may get additional business.
For these companies, the earnings outlook and risk assessment may well paint a very different picture of what each business is worth currently.