Our customers often ask us this question:
ValuAdder offers a number of business valuation methods. Does using multiple valuation techniques reduce business risk?
Our answer is this: applying a number of methods to value a business helps you reveal and assess the business risk much better than using just one method.
Appraising a business based on its cash flow
Let’s say that you are valuing a company and decide to use the Discounted Cash Flow method. This method relies on the discount rate for business risk assessment. The classical Build-Up model to calculate the discount rate works as follows:
- Start with the risk-free rate of return. The yield on long-term US Treasuries is a common choice.
- Add the equity risk premium – the additional return you get investing in the stock market.
- Add the premium for company size – since smaller firms tend to be riskier than Fortune 500’s.
- Add the industry-specific risk premium.
- Assess the company-specific risk and add the corresponding premium.
Usually, the company-specific risk assessment is the hardest part, and the greatest cause of mistakes. Needless to say, improperly calculated discount rate will give you erroneous business valuation results.
A different perspective – market based business valuation
To verify the results your get with the Discounted Cash Flow method, you may consider using the market-based valuation techniques. Here, you study the recent sales of comparable companies. You can see how other business people assess risk by calculating the valuation multiples they applied when valuing the businesses they bought or sold.
Review of statistically derived valuation multiples gives you an idea of the levels of risk for companies similar to yours. While each business is unique, sharp deviations from the industry norm call for an explanation and may point out an error in your analysis.
Asset based business appraisal – another view of business value
You can also add asset-based valuation methods to shed further light on business risk. For example, using the Capitalized Excess Earnings Method shows just how well the business generates returns for its owners, given the capital invested.
Notice that the various methods adopt a very different view of business value. Yet all these different perspectives complement each other to expose the same fundamental drivers of business value – risk and return.