Assessing risk is a crucial part of valuing a closely-held business. Business appraisers use risk assessments in the income approach to estimate rates of return (discount rates) and in the market approach to select valuation multiples. All else being equal, the higher a company’s risk, the lower its value, conversely lower risk (value drivers) increases value. Benchmarking compares the company to its competitors, and/or against itself overtime to assess any risk factors or to show any value drivers.
A comprehensive benchmarking study, sometimes referred to as “financial analysis”, compares various financial attributes of the business against industry averages or specific competitors. If a financial attribute falls into an unfavorable category, this generally signifies a higher risk.
Business appraisers use various strategies in benchmarking a company’s financial performance. Three typical examples:
- Historical Time Series. As a starting point, appraisers will spread a company’s financial information and compare the company against itself over time to ascertain changes in dollar amounts.
- Common-Size. This type of analysis presents line items as a percentage of sales or total assets. This helps explain how each dollar of sales is dispersed between costs, expenses and profits.
- Ratio Analysis. Appraisers typically use ratios calculated using the company’s income statement and balance sheet line items. Benchmarking the company against its industry, helps identify any risk factors or value drivers the business has.
Growth & Profitability
Typically, appraisers measure growth by the percentage change in sales, profits and/or market share from year-to-year. Steady upward growth is ideal, while rapid growth can be just as dangerous as a rapid decline. Businesses that grow too fast have an insatiable appetite for additional cash (increase in working capital) to support higher growth. Oftentimes the business owner tells us that historical growth (slow) is not indicative of what growth is forecasted to be moving forward. When this occurs, our firm prepares a financial forecast (income statement and balance sheet) using the owner’s growth assumptions and then we ask “how will you finance this fast growth assumption?”
More often than not, the business does not generate enough profit to support their growth assumptions. Can the business take on more debt? Debt-to-equity ratios shed light on this issue, by comparing the business with its industry peer group.
How can American Business Appraisers help?
Business valuations require a significant amount of careful consideration and judgment. Our experienced staff recognizes and quantifies a business’ risk factors and value drivers. The more risk factors a business has, value is driven downward. On the other hand, identifying value drivers will increase the value of a business.
Call us to discuss any specific valuation needs. Every individual situation is different and not everyone requires our certified appraisal services and sometimes just talking with one of our appraisers is all that may be necessary. With our initial consultation, there is no cost or obligation to you. We promise you two things; first, to invest a reasonable amount of time to gain an understanding of your specific requirements, and second, our communication will be kept confidential. We invite you to visit our website at www.abavalue.com to see for yourself the services we offer, along with our qualifications.