If you are valuing a privately owned business, the income-based valuation methods are probably high on your list of tools. To use these methods, such as the Discounted Cash Flow technique, you need to determine the discount and capitalization rates.
Income based business valuation methods and company size
If you take a look at the Build-Up formula for calculating the discount rate, you will notice that the company size risk premium is one element. For a public company this is determined based on its market capitalization. This, of course, requires that you know the company share price and the number of shares outstanding.
How to estimate the size of a privately owned business
Since the market share price is usually not available for a private business, you need a different way to determine its size. One approach is to come up with an estimate of the equity value of the company, then use this to look up the size risk premium for your discount and cap rate calculation.
You can use a number of market-based valuation multiples to do this. For example, use the gross revenue based valuation multiple and multiply the most recent annual business revenues to come up with the business enterprise value of the firm. Subtract total debt from this for a quick equity value estimate.
Now use this figure to look up the appropriate company size risk premium and calculate your discount rate. You can then determine the value of the business with a high level of accuracy and cross check your results against the market-based estimates you developed earlier.
Business Valuation using All Three Approaches
One of the key elements in business valuation of any size is risk assessment. Whether you use the direct capitalization methods, such as the Multiple of Discretionary Earnings technique, or the Discounted Cash Flow method, you need to calculate the capitalization and discount rates to capture that risk.
Business valuation and risk measurement
The Build-Up model is perhaps the most common way to calculate the discount rates. If you take a look at the build-up formula, you will notice that the company size risk premium is one key element. Generally, the smaller the company, the riskier it is and the higher the corresponding size risk premium number.
Small companies are riskier than larger competitors
So how do the company sizes affect their risk in this economy? The spread may be surprising to some. In fact, for small public companies with market capitalization below $50M the size risk premium exceeds 13.9%.
On the other hand, larger mid-market firms with market cap above $500M have a size risk premium falling below 2.84%.
Business value is affected by company size
This means that, for example, the equity discount rate for a $50M company in the construction industry can be around $26.7%. For a $500M counterpart, the discount rate is just 15.65%.
If both companies show minimal earnings growth in 2011, each $1,000,000 in net cash flow of the small company is worth about $3.75M compared to $6.39M for the larger firm, a 71% difference in business value!
Business risk rises quickly for smaller firms
What is interesting is that the size risk premium does not vary smoothly with company size. In fact, the relationship looks more like a hockey stick with a break point somewhere around $150M in market capitalization.
Size matters: Key business value enhancing factors for bigger firms
What makes the larger companies seem so much less risky in the eyes of business people today? Here is our short list:
- Market and product diversification of larger companies reduces their risk.
- Larger companies have succeeded in building very strong balance sheets to manage their financial risk better.
- Bigger businesses have a much easier time attracting capital – both debt and equity.
Business Valuation for Firms of any Size