March 21, 2016
When you buy a new car, what exactly are you purchasing? You are buying a tangible asset, a method of transportation and often a symbol of taste and stature.
When someone buys a company or an interest in a company, what are they purchasing? Not necessarily always a tangible asset, but always a method to obtain future economic income or cash flow.
Economic income is defined by Paul A. Samuelson and William D. Nordhaus in their text Economics as “the flow of wages, interests, payments, dividends, and other receipts to an individual or nation during a period of time.”
There are several ways to value a company, but this article will focus on the income approach.
The income approach calculates the value of a company as the present value of the anticipated future economic income to the buyer. Under the income approach, two methods can be used to calculate value: discounting all the future economic income or capitalizing the economic income of a single period.
The capitalization of economic income method is one of the most common methods to calculate the value of small companies.
In the capitalization of economic income, the income for a single period is divided by a capitalization rate to calculate value. The components of this capitalization rate are imperative to the valuation analyst’s estimate or conclusion of value. The buildup of a capitalization begins with the risk-free rate at the date of valuation.
A risk premium must be added to the risk-free rate. There are typically three components to the risk premium: equity risk, size risk and specific company risk. The risk premium is the incentive for the buyer to invest in the market (equity risk), as well as in a small company (size risk), and to invest further in the company being valued (specific company risk).
In assessing the risk of investment in the specific company being valued, quantitative and qualitative factors must be analyzed. Because there are a significant number of factors that may or may not be relevant, it is important to obtain an understanding of the company being valued and the applicable risk factors.
An analysis of the historic trends of the company can be used to assess risk in the company’s financial health. Factors such as debt leverage, receivable turnover, volatility in revenues, gross margins and/or operation margins are examples of a company’s financial health risk.
When using the historical trends in analysis, you can compare the company to itself, which is a valuable tool. The use of industry benchmarking data is also valuable. However, you need to be careful that the industry data being used is comparable to the specific focus of your company.
The industry in which the company operates could increase exposure to risk. The amount and character of the competition that exists in their marketplace, as well as location of the company, can create risk. The company’s required compliance with any industry or government regulations can also generate risk. In addition, any legal or litigation issues with the company pose great risk to a potential buyer.
Another factor to consider in assessing risk is to analyze the company’s customer base. A company with a large amount of its revenue from one or a few customers could potentially be very risky. At the same time, a company with a significant amount of revenue from related parties or entities could also be a significant risk.
A company that produces a product line or service for a very specific or limited market has exposure to considerable risk.
Management and operations of the company are other areas to analyze when assessing specific risk.
Companies with one key individual managing the organization are risky just in this factor. This risk could also apply to a nonmanagement key individual, such as a salesperson or operations manager.
Other aspects in this area to consider are information technology systems, internal controls in place within the organization, its reliance on fixed assets, and the condition and life of the assets.
The risk associated with purchasing a company or an interest in a company, especially a small company, can be significant.
It is vital to a valuation analyst to assess the specific risk premium of the company they are valuing to ensure the incentive to the buyer is acceptable.