The methods used to value businesses are several, each having varying degrees of complexity. Perhaps the most basic is the net book value of a business’s assets. This is vulnerable to accounting conventions like depreciation. It might be tempting to restate assets to their break-up value, but even here no consideration is given to the business’s future earning potential. Other methods try to overcome these problems are by using past earnings and multiples but even here, there is no guarantee that past performance is any reflection on what the business can achieve in the future. From a scientific perspective, there is consensus that the most reliable business valuation model is the discounted cash flow method which focuses on the generation of future net cash inflows and gives due consideration to the risk associated with the venture. The risk is expressed as the minimum rate of return at which investors would be prepared to stake their money in the business.
At the heart of discounting, is the concept of the time value of money. This basically refers to the fact that a euro spent or earned now is worth more than a euro spent or earned in the future. There are three principal reasons why this is so.
One
Inflation has been a major issue for most of the twentieth century. During periods of inflation the purchasing power of money is eroded so that what can be purchased for a specific amount in one year will cost more in future years.
Two
Prospective future cash inflows are always uncertain whereas cash currently in hand has a certain value. The risk implicit in future cash flows has a cost and this is reflected in a universal preference for current money over future money.
Three
Using the financial markets, an individual may invest current cash holdings and earn a return. Assuming €9.09 can be deposited at a rate of 10%, the investment will be worth €10 in a year’s time. Logically, this means that the €9.09 is worth more now than an identical amount at any time in the future.
The falling value of money is an important factor in investment appraisal because once the expected cash flows of a project are identified, consideration must be given to when they will occur. An investment of €10,000 which yields €12,000 within one year is worth more than one which yields the same amount in two years’ time. The issue is complicated further when projects of different sizes are compared, each with a different chronology of cash flows. The difficulties are overcome by choosing an appropriate discount rate so that all cash flows may be translated to a common basis – which is normally the current deemed value of money. The project with the highest net present value or the highest internal rate of return, depending on the appraisal method used, will be selected by the investor.
The chosen discount rate will reflect the firm’s expected return on the project being contemplated. Thus, if a firm would like to earn at least 13% on its projects, it will reject those investments where the internal rate of return is lower than this figure.
The chosen rate will be based on other rates of return currently prevalent in the market, and risk and uncertainty factors inherent in the project being appraised. The general rates of return available in the market provide an opportunity cost for the project in question. This means that if the firm knows that it can earn, say, 12% by embarking on another investment of a similar risk profile, all those undertakings which yield a lower return should not be considered.
However, the problem with opportunity costs is that even this alternative return is plagued with uncertainty. The firm cannot be sure of earning anything on any project until it is complete and the returns confirmed. To be able to start from a point of relative certainty, most appraisers require that the project earns at least the risk-free rate of return which the market makes available. This is normally the return associated with U.S. or German government stock or bank deposits where risk is virtually zero.
The second step is to add a premium to reflect the uncertainty of the returns. No rational investor would choose uncertain over secure returns unless there is adequate compensation for the risk involved. The amount of the premium is directly dependent on the nature of the project. Therefore if the firm is simply trying to produce goods which have already been accepted by the market, it will choose a lower premium than if it were to launch a completely new product.
A further premium has to be added to reflect the way the project is financed. The principal forms of finance are equity and debt. Equity has the advantage of giving the firm more control over its cashflows by timing the expected returns (dividends) to suit its liquidity requirements. On the other hand, debt is cheaper because of the lower risk, and it is also allowable as a deduction for tax purposes, but there is almost no flexibility in delaying capital and interest payments. The extent to which the company is geared also has a bearing on the financial risk premium so that the higher the gearing the higher will be the expected return by the providers of funds. Other premium components may be added as needed to take into consideration industry risk, risk associated with corporate size and other risks specific to the entity. An adjustment to the discount rate is normally also made to account for the beta factor associated with the corporation’s line of business.
Finally, it has to be accepted that a fair degree of arbitrary evaluation is always present when deciding on a discount factor. The problem is that unless a careful assessment is made there is the danger of selecting an excessively high discount rate thereby rejecting projects that would otherwise have been acceptable. Conversely, if a low rate is adopted, the company runs the risk of accepting projects with sub-optimal returns.
So, when would it be necessary to value a business? Obvious examples are business disposals, estate planning or succession, litigation between participating investors, marital breakdowns or the onboarding of a strategic partner. However, valuations might even be necessary upon bankruptcy/liquidation or for the purposes of financial reporting or compliance. In such situations, stakeholders would need to rely on a valuation that is financially sound and unadulterated by such biases like accounting conventions and provisions, and that takes into consideration what is perhaps the most critical variable of all: that of perceived risk.
ABOUT THE AUTHOR
Vince Mifsud is a Consultant at Credence.
You can get in touch with Vince via email.