Every business valuation relies upon a set of assumptions about how the economic environment will look some time in the future. Once the assumptions are made, the business appraiser can make forecasts for the business being valued.
If you take a look at a typical business valuation report, there is usually a section outlining the economic conditions. This discussion is useful to the extent that it helps the reader understand how the business will be affected by the overall economy in the future.
This is because business valuation is about the expectation of what might happen at some future point. The business earnings forecast can then be made and used as a key input into your business valuation analysis.
You will make the economic conditions section in your business appraisal report more useful if it focuses on what the future economic prospects are likely to be. The remainder of the business valuation should tie these expectations with the business value analysis and calculations. This way the reader can carefully review the economic outlook discussion, spot the assumptions made and see how the appraisal ties it all together with the business value results.
You may have heard this: business value fluctuates as time goes on. Fair enough, but the question you may ask is what factors best capture this change? Here is our short list:
The reason these numbers are in a constant state of flux is that the marketplace conditions vary quite a bit. Most of this variation happens because the investors reassess the risks and change their investment strategy accordingly.
If the market is edgy, business people tend to take a conservative stance for a while and see how things turn out. This usually means pulling resources from risky investments and parking them somewhere safe.
The discount rate captures a company’s risk, so it is not surprising that this factor will change as risk changes. If you take a closer look at what goes into the discount rate build-up formula, you will see how this may happen.
For instance, risk free returns may change as the government makes policy changes to its policy. The equities market as a whole may be seen as more or less risky due to major political or economic changes underway. Specific industries may enter a period of expansion and lower risk. Smaller companies may face bright prospects for growth and attract a lot of investor interest, lowering the required rates of return.
On a smaller scale, the company being valued may well be going through some changes that can affect how its riskiness is seen by investors.
The capitalization rate, being the difference between the discount rate and earnings growth, is also easily affected over time. Just imagine the typical swings in business earnings that may change the cap rate at any time. Since business value grows with lower cap rates, healthy earnings growth prospects tend to increase the company’s value.
Valuation multiples are similar. Since they are derived from comparable company sales, you are looking at how other investors see the current business risk when buying businesses of a certain type. This is useful because you can assess the business risk for you company by checking what other investors think about similar companies at the moment.
You might think: if all business appraisers follow the standards such as USPAP and AICPA SSVS how come the results differ? The main reason is that clients influence the outcome of professional business valuations. Business people have a reason for business appraisals and an idea of their own of what the company is worth.
The reason may affect what a client expects to see in a business appraisal. A buyer would prefer a lower number than a business seller. Just about all business valuations are used in some kind of negotiation – between business partners, in tax situations, financial reporting, raising funds or acquisitions.
It is likely that each party will have their own business appraisal and the results will differ based on the clients’ expectations. In theory it is possible to come up with an impartial business valuation. However, neither party is going to be satisfied with the figure.
In most real world situations the appraiser is acting as the client’s advocate. He or she is expected to support the client’s position by gathering the supporting evidence. In this sense the business appraiser is objective but not really independent.