When an economic downturn strikes, one thing is sure to follow: business sales grind down to a halt. In uncertain times moving forward with a major investment entails risk.
Business buyers stay on the sidelines afraid to make a bad acquisition that goes south. Business owners step back unwilling to sell their companies for a pittance. Low ballers and bargain snatchers may be the only ones left to fish in muddy waters.
Market comps must be plentiful and recent to be useful
In a stable market, comparing your company to similar businesses that sold in the past is common practice. Business selling prices, when such sales are plentiful and recently closed, provide a good indication of what companies are worth.
But what can you glean from the market when few if any businesses sell? If the market shifts rapidly due to a man-made or natural disaster, you need to know the effect on business value. Otherwise, you risk making wrong decisions that can be costly.
In fact, the leading business valuation standards, such as USPAP and International Valuation Standards (IVS) state clearly that market comps must be readily observable, large in number, and recent to be of use. If the bottom drops out from under the business sales market, you may have a hard time getting reliable data on which to base your business valuation decision.
So if the market comps are not trustworthy or simply not available, what remains?
Recall that there are three ways to value any business, called approaches: asset, income, and market.
If the market approach seems shaky, focus your attention on the other two. When market risks are all over the map, it is time to resort to the income based valuation.
Income based business valuation may be your best bet
Why such focus? Income valuation does not need to compare against non-existent or questionable transaction data. Instead, you focus on the analysis of the business itself, namely its earnings prospects and risk.
Forecasting business earnings in uncertain times may be a challenge. If in doubt, use several forecasting scenarios that could cover a range of possibilities. How about the worst and best case?
Back to basics: risk, return and business value
Note that such forecasts are intended to capture realistic expectations of business income. In addition, you need to estimate the discount or capitalization rates to represent the business risk going forward.
With these sets of numbers available, you can use the standard discounted cash flow or direct capitalization methods to estimate your business value. The range of values tends to get wider as market uncertainty increases. No one has a crystal ball.
If you do your homework right, income based business valuation may be a good tool to estimate business value when the market comps fall short.