If you are valuing a private company, one of the key elements of the appraisal is assessment of the business risk. You can quantify your risk assessment as the discount or capitalization rates. To calculate these rates use any number of the cost of capital models such as the build-up or CAPM.
Regardless of the model you use, you will notice that they rely upon the estimation of the so-called equity risk premium. This risk element captures the overall uncertainly as to the size and timing of returns from a diversified portfolio of public company stock investments.
You can use such public capital markets information to assess the risk of a privately owned business. Prudent investors rely on the public market data to make decisions on investment in a public or private company. They will invest in a given company if the returns they receive are commensurable with the risk. So the equity risk premium is an opportunity cost that the business owners incur to attract and retain the much needed capital for their business.
Along with the risk-free rate of return, the equity risk premium sets the lower limit on any privately owned company discount rate. In other words, smart investors will not put their money into a company unless the returns they get match or exceed the sum of the current risk-free return and the equity risk premium.
Usually, risk associated with a privately owned company will also include such elements as its size, the industry sector it operates in, and a set of company specific risk factors.
Valuing a Business based on Risk and Return
If you are thinking of valuing an environmental consulting company, here are some key industry statistics to ponder. The industry sector, classified under the SIC code 8748-9905 and NAICS code 541620, consists of over 10,220 firms; mostly in private ownership. The industry sector as a whole generates about $13.4B in annual revenues.
The average environmental consulting company produces roughly $1,300,000 in sales per year with a staff of 7 – 8. The S corporation is by far the largest entity form in the environmental industry with over 6,300 companies formed as S corporations. Over 90% of the companies in this industry have 50 or fewer employees.
Many companies specialize to provide high value services to their public and private clients, including:
- Environmental management consulting
- Environmental inspections, service assessment and remediation
- Hazardous waste disposal
- Resource conservation
- Energy infrastructure management
- Technology and information systems consulting
Business valuation of environmental consulting and engineering companies
Strong relationships with existing clients and new business referrals tend to contribute to steady earnings and solid project pipeline that ensures the company’s future. Successful environmental businesses often become respected institutions in their market which fuels business growth.
Such profitable firms are highly desirable acquisition targets. Recent selling prices in the sector can provide you with a foundation on which to base the appraisal of your own company.
The usual way to do such market-based comparison of business value is to use the valuation multiples. These are the ratios that relate the business selling prices to the sold firms’ financial performance measures.
Here is the short list of typical valuation multiples you may consider in valuing an environmental consulting business:
Example: Environmental consulting business valuation using multiples
To demonstrate the idea, let’s pick a typical professional environmental company with the following financials over the last twelve months:
- Revenue (net sales): $800,000
- EBITDA: $250,000
- SDCF: $323,000
- Total business assets: $370,000
- Book value of owners’ equity: $545,000
Next, we use the the valuation multiples derived from similar sold firms so that we can calculate the business value for our sample company:
|EV to net sales
|EV to EBITDA
|EV to SDCF
|EV to total assets
|EV to owners’ equity
|Average Business Value
Surprised by the spread of values in this table? Actually, this is not unusual when doing market comparisons. The reason is that each company is different. So, for example, our sample business profitability, expressed as EBITDA, is high for its level of sales.
In addition, the owners have accumulated considerable equity, perhaps by retaining earnings or managing the company capital structure with minimal debt. As a result, the business value estimates based on these two measures appear higher.
Alternatively, you can view these results as establishing a range of values for the business, from low to high like this:
Business value range: $840,000 – $1,065,000
Business Valuation Using Multiples