One of the common questions in valuing businesses of different sizes we hear often:
Are there differences in value between companies of different sizes? If so, how does the difference factor into business valuation?
The fact is that when it comes to business valuation, size matters. This makes intuitive sense if you spend a bit of time checking out the behavior of investors in the public capital markets.
Investors tend to be far more demanding if the company they invest in is smaller. Larger companies, on the other hand, tend to have an easier time attracting investors content with lower returns.
Why such difference? The simple answer is risk. Indeed, it is common knowledge that smaller firms tend to be more risky than their larger counterparts. Big companies have more resources, are usually better diversified in their product offerings, play in a number of markets and have well trained and highly compensated management and key employees.
Well managed large companies use these advantages to produce more predictable, steady earnings over time. Since the essence of investor risk is uncertainty, dependable earnings are valued highly.
For each dollar of investor money, smaller companies generally need to show greater returns than the well established larger competitors. In the language of business appraisal all this points toward value increase as the company size grows.
One of the ways this difference in value can be captured is in the discount rate. If you take a look at how the discount rate is calculated, you will notice that one of the elements is company size premium.
The smaller the company, the greater the size premium. Since the discount rate appears in the denominator of business valuation calculations, such as the discounted cash flow method, the effect is to reduce the business enterprise value.
How much of a difference does size make? As it turns out, quite a bit. The largest multi-billion dollar firms may require the size premium in the 1% – 2% range. Compare this with the smallest companies with market cap at or below $100M that can have a size premium of well over 10%.
To put this in perspective imagine a very large and a very small company in the same industry sector. The capitalization rate for the large firm may be 25% whereas the small company value calculation will call for a cap rate of 35% or so.
For each $1M in capitalized earnings the difference in value will be:
- Large company: $4M
- Small company: $2.86M
That’s a value difference of some 40%.
So for a given level of earnings, the company size premium will tend to reduce the business value. This is consistent with the market demand for greater returns from smaller companies.
The same logic applies to capitalization rates since they are derived directly from the discount rate for the company. Use caution when working with valuation multiples derived from business sales comparables. These multiples must account for the size of company you value correctly. In other words, the sample of business sales you use to come up with your valuation multiples must include companies whose size is about the same as the company you value.
If you are valuing a private company risk assessment is one of the key steps. Business value depends on the company’s earning capacity at a certain level of risk. The greater the risk, the greater the returns should be to justify the investment. This risk assessment is typically represented by the discount and capitalization rates you use in your business valuation calculations.
If you look at how the discount rate is determined, you will see a number of elements that make it up. One of these is the so-called company specific risk premium. This element of the discount risk is unique in private company valuations.
In fact, public company investors generally do not seek additional returns by investing in a specific company. What they do instead is diversify their investment by putting their money in a number of firms. Hence, for the purposes of valuing a public company, the company specific risk premium is 0.
The situation is quite different if you need to value a privately owned firm. Business owners, who often represent the major investors, are unlikely to be well-diversified. Instead, they tend to focus on the company often to the exclusion of other attractive investments.
With this level of focus comes additional risk. Unlike the other risk elements such as those associated with the company’s industry sector, this risk is defined by the company itself.
So to assess just how much additional risk the private company investors incur, you need to look at a number of factors:
- How the company’s revenue growth compares to its industry peers.
- What level of financial risk, such as raising debt capital, the company takes.
- How risky the operations are in general. Is the firm easy to run? Are major investments required for expansion?
- How profitable is the firm?
- Is most revenue derived from just a few customers?
- Does the company have a large number of products and services?
- Is the firm’s market large enough to support future growth?
- How strong is the competition?
- Does the company have a talented and effective management team?
- Are the employees skilled and motivated to do their jobs?
Depending on the answers to these questions, your company may experience additional risks that change the discount rate. Generally, the higher the risk across any of the factors the greater the company specific risk premium.
Are the above risk factors considered by public company investors? The answer is yes. However, most investors in public companies usually own just a small part of the business. Such minority owners cannot affect the decisions that a company must make in order to change these risk factors. Instead, the investors choose to reduce their overall investment risk by spreading their money across many public firms.
Put differently, the public capital market does not reward the investors for limiting their portfolio to just some companies.
In contrast, owner-managers of private firms have a lot of say in how their company is run. So they can make strategic decisions that affect such company specific risk factors. In other words, these investors usually have control over how much company specific risk exists.
ValuAdder includes a risk assessment tool that helps you estimate this type of business risk. You rank the firm across each of the factors above by assigning a risk weight to each. The result is a calculated company specific risk premium that is added on top of the other discount rate elements.
ValuAdder offers you worksheets to assess the company risk for your business valuation. This includes company specific risk premium that often arises in valuing privately owned companies.
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You may ask: if all business appraisers follow professional standards such as USPAP and SSVS, then how can business valuation results be so different? The reason is that clients who order business appraisers have a number in mind beforehand. The client wants a certain result and is rarely content with just knowing the answer.
There is always a reason why a business valuation is done. Say one party wants to value a business for buying, and the other is selling. In this case the seller is likely interested in a higher number than the buyer.
An impartial observer asked by both parties may be able to arrive at a neutral answer that may be described as a fair market value but please neither party. Such situations where both parties agree in advance to a binding answer are rare indeed.
What is more likely is that both parties are in negotiation with each other and are looking for evidence supporting their position. Think about tax disputes, borrowing funds, financial reporting and a business sale transaction.
In such situations where parties are looking to their self-interests, the business appraiser acts as an advocate for the client. The clients are likely to hire their own appraiser who is expected to support the client’s position.
Two questions arise here: can an appraiser be objective? Can the appraiser also be independent?
In cases of dispute it is possible for a professional business appraiser to be objective. But what about independence?
Indeed, independence of the client and absence of any material interest in the business being valued are required by all professional business valuation standards. The appraiser is expected to earn the fee based solely on the time and effort spent on the valuation assignment.
Objectivity involves making realistic assumptions. All business valuations rely on an assessment of the future economic conditions. Two appraisers who come up with drastically different results are likely making very different assumptions.
Future outcomes cannot be foretold with certainty. Thus, business appraisers have considerable leeway in judging the likelihood of some events taking place.
Think about a major product launch that is planned. A business appraiser may want to include the additional value creating potential of this product into the business value. Yet the product introduction is yet to be tested and its full effect felt by the business.
An adverse party may hire an appraiser who might assume a much less rosy scenario for the product introduction. The appraisal may conclude that the business value is far lower as a result.
So by changing the assumptions about a material event you can arrive at very different business valuation results. Neither answer is right or wrong – they are simply based on two sets of assumptions.
To sum up, business appraisals can seem objective, yet have very different answers.