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.