Do Your Own Business Valuation ? Part 4 Quantifying Business Risks

The basic concept of business value is that the future benefits (return) of owning a company must be adjusted (discounted) for the risks associated with owning the company The sales or earnings of a company are typically used to represent the benefits (return)

The basic concept of business value is that the future benefits (return) of owning a company must be adjusted (discounted) for the risks associated with owning the company. The sales or earnings of a company are typically used to represent the benefits (return). Multiples and rates are used to represent the risks. The sales and earnings figures are already recorded as numbers, but how can risk be quantified? Multiples and rates are the results of various methods to quantify these risks.

Specific Risk Factors

One way to accomplish this is to evaluate a number of specific factors affecting your company and ranking their level of risk. The factors considered should cover all aspects of the business like management, operations, financial, workforce, sales and marketing, legal, environmental, regulation, and competition. A simple scale from 1 to 3 can be used to assess the risk level - 1 = very high risk, 1.5 = high (above average) risk, 2.0 = normal (average) risk, 2.5 = low (below average) risk, and 3.0 = very low risk. The average score is multiplied by the cash flow or earnings of the company.

Payback Period

Another way to calculate a multiple is to consider how quickly you would want an investment in a company to be recovered through its earnings. A riskier company would require a shorter payback period. Small companies are often expected to have a payback period between 1 and 3 years. The average score from the specific risks method (from the previous section) can also be used as the payback period. The payback period is multiplied by the cash flow or earnings of the company.

Expected Return on Investment

Another way to look at risk is to determine what rate of return would be required to make the risk level of the investment acceptable. For example, a bank certificate of deposit is very safe and has a low rate of return (interest rate). An investment in a small company is typically expected to have a rate of return greater than one in a publicly traded company (up to 15%), but less than a venture capital investment (more than 40%). I have found that most small companies are valued using a narrower range between 25% and 35%. You can use the specific risk factors method (described above) to determine the rate of return - 1.0 = 35%, 1.5 = 32.5%, 2.0 = 30%, 2.5 = 27.5%, and 3 = 25%. These rates of return are referred to as capitalization (cap) rates.

The earnings of a company (for one period, or the average earnings for a number of periods) are divided by the capitalization rate to calculate its value. If the rate is to be applied to a company?s earnings for multiple periods as a series (not average or median) then a growth rate must be added to convert it to a discount rate. Using discount rates is an advanced valuation technique that is not covered here.

Industry Formulas (Rules of Thumb)

Some industries have formulas that are widely used to determine business value, often called rules of thumb. Rules of thumb are expressed as a range of multiples that quantify risk within that industry. Selecting a multiple within the range to accurately match the risk level of your company is critical to getting a good result from industry formulas. One method is to use the average score from the specific risks method, described above. A score of 1.0 would correspond to the lowest multiple in the range, 3.0 to the highest.

One of the most extensive listings of these formulas is published in an annual Business Reference Guide from Business Brokerage Press. You may also be able to get formulas for your industry from a trade group or association, or your CPA.

Conclusion

Quantifying the risks associated with owning a company is a difficult and theoretical process, so it is often ignored or arbitrary. The methods described in this article provide relatively easy and logical ways to calculate the multiples and rates needed to complete the basic business valuation formula of value = returns/risks.

David Coffman recently published the Do-It-Yourself Business Valuation Workbook. David is a Certified Public Accountant who is Accredited in Business Valuation (ABV), Certified in Financial Forensics (CFF), and a Certified Valuation Analyst (CVA). His firm, Business Valuations & Strategies, offers low-cost business valuations.