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.