Archive for November, 2013

One of the most pressing questions that keeps coming up in business appraisals is the difference between values of companies of different sizes. Common sense tells us there is a difference between a multi-million dollar corporation and a small main street shop.

If you ask a professional business appraiser, the answer is likely to center around the concept of risk premium. Business valuation is about the assessment of a firm’s earning power and risk. The value is higher the lower the risk and the greater the earnings.

For a given level of business earnings the value is defined by the risk. To assess the company’s risk, you need to consider a number of factors. One of these factors is company size. For public companies the size is usually defined by the market capitalization.

Small company risk premium

If you think that smaller companies are riskier then you are not alone. In fact, most professional investors put their money in smaller companies because they expect to be rewarded by higher returns than those expected from a large established firm.

If you pay close attention to the public capital markets, you will note a lot of public companies competing for investor money. Risk and return are related, in fact the additional return small companies must provide to attract investment is a measure of the additional risk these companies entail.

Take a look at the build-up cost of capital formula. Note that the company size is one of the elements that make up the so-called equity discount rate. The discount rate and its close cousin capitalization rate are measures of the firm’s risk.

The additional risk one takes for investing in a smaller firm is called the company size risk premium. It represents the additional return the business must generate to attract the investment capital. In other words, for a given level of earnings a larger company is more valuable than its smaller counterpart.

Valuation multiples – another look at the size risk premium

Another way you can compare the values of companies of different sizes is to observe the selling prices of businesses put on the market. Again, the smaller companies tend to sell at relatively lower valuations than larger ones.

You can capture this difference in value by calculating a number of valuation multiples. These ratios relate the business selling price to a measure of its financial performance. So a gross revenue multiple relates the business gross revenue to its value. To calculate this value, multiply the gross revenue multiple by the company’s revenue.

Valuation multiples also incorporate the company size risk premium. This means that you should calculate your multiples from companies of similar size or market capitalization. Usually, you would want to gather business selling prices from a number of recent transactions involving companies that are similar to each other and of about the same size.

Which valuation multiples are best? It depends. In some industries the revenue based multiples are preferred. Examples are professional practices and rapidly growing businesses. On the other hand, valuation multiples based on the company’s profitability are best in stable income-producing market segments. Asset rich companies may be valued based on their assets.

Business Valuation based on the Return and Risk

You may have heard this said about running a business – cash is king. You will find that cash is also important in business valuation, especially when the calculations involve the income-based methods.

The idea behind these valuation methods is to determine the business value based on its earnings generation capacity given a level of risk. The central question is: what type of income can the owners expect to get out of the business?

To make the valuations work, you would need to make a selection of the income, usually some form of cash flow. The cash available to the business owners is what is left over after the funds required to run the company have been accounted for. Business appraisers use a number of well known cash flow definitions in their analysis, including:

For owner-operator managed small businesses, the SDE is an excellent choice. It represents the level of available cash flow the hypothetical business buyer can expect upon a business purchase. Net cash flow is often used to value larger companies and demonstrates the returns business owners can remove out of the business without negatively affecting the operations.

If you take a closer look at the actual elements that make up the SDE and NCF cash flow measures, you will see how the important requirements have been accounted for. For example, business owners cannot expect to dip into the bank for distributions or salaries until after the capital requirements have been met. New equipment must be bought or existing machines properly maintained so that the company can keep producing the income. The same goes for the short-term investment in working capital such as the need to increase inventory before a seasonal increase in product demand.

Unusual or one-time expenses can skew the available cash flow. In such cases, you may wish to adjust the cash flow calculation to remove these items. For example, moving expenses are not likely to be incurred regularly, so for the purposes of business valuation you can factor out these charges.

On the other hand, if the current owners count rental income from unrelated real estate as part of their income, the available cash flow needs to be adjusted downward since the income is not due to business operations.

Business Valuation based on Available Cash