by Greg Caruso | Aug 4, 2021 | Technical Business Valuation Topics
By Gregory R. Caruso, JD, CPA, CVA
In the July/ August Issue of The Value Examiner, the publication of the National Association of Certified Valuators and Analysts (NACVA), I wrote about two common mistakes I see when valuators use the income approach with small businesses. Here is an overview of those two mistakes, or you can read a PDF of the article by clicking this link:
Understanding company-specific risk in business valuation.
In my last blog post, I explored some of the concentrations and risks that small businesses face. The risks that large companies have are not the same risks that small businesses have. The income-based method captures risk with the company-specific risk premium (CSRP), but I’ve seen this understated too many times. I explain in the article that different methods will give different discount rates, and those will change the value of the company. Valuators who do not regularly value small businesses often understate the risks associated with them.
Understanding long-term growth for early-stage and growth-stage companies.
The second mistake I often see is understating the long-term growth of small businesses in an early or growth stage. For example, using a 10% growth rate in the capitalization of earnings method gives you completely unrealistic results for cash flow over time. However, because present value discounting is also part of the process, it may not give you an unrealistic business value. In the startup and growth stages of a business, that business might experience annual growth rates of 100% range or more, but often average 10–35%. At some point, the companies level off. Knowing the business growth cycle and which phase the business is in helps you evaluate cash flows and the company more accurately.
Valuation is an art and a science, and often experience and practice helps with understanding the art. Contact me to learn more about my valuation services or learn more about the Art of Business Valuation in my book.
by Greg Caruso | Apr 3, 2020 | Technical Business Valuation Topics
Coronavirus, caused by Covid – 19 has raised new issues to consider when preparing business valuations. Many businesses are going to struggle to stay in business to hopefully rebuild business value on the other side of this contagion. A few considerations for business valuations in a world with Coronavirus are below.
Known or Knowable – It may be unclear when the effects of the coronavirus become known or knowable as it affects business valuation. In addition we clearly do not really know what is going to happen next (perhaps better or worse) at this point from Covid – 19. But, we need to address it based on what was known or knowable as of our valuation date. Here is a timeline from the New York Times giving some key dates and history of official actions on the coronavirus that could be useful for business valuation. Was this known or knowable on January 31, 2020, February 28, 2020? I’m not sure. It certainly was known by March 15, 2020 when the CDC recommended restricting gatherings to 50 people or less. Is this actually a regional issue? In New York area it was clearly a problem in early March. In Colorado things seemed normal in many places until mid-March.
Handling subsequent events – Until the effects of the virus on the economy were known or knowable as of the valuation date the Covid – 19 issue is a Subsequent Event. Subsequent events are events that probably would change the business value found if they were considered but they are not considered because they are after the valuation date, but obviously, before the report issue date. Another question is just how serious a warning do you need to give about the affects of coronavirus in the business valuation. For many industries and businesses this is a huge adjustment not just a little more or less risk. I recommend giving a clear analysis that the effects on the economy as a whole are going to be very large and work down to the business at hand while making it clear this has not been factored into the final business value found.
Business valuation methods depend on modeling. When business valuation models become unreliable due to the effects of coronavirus the results of business valuations become unreliable. Here are some charts and commentary on the current state of the economy the impact business valuation. Note that these results are beyond what economists or business valuation experts know how to model as they are outside anything ever seen.
Business Valuation is about predicting future cash flows. Issues in predicting future cash flows include:
- How bad are the economic effects of coronavirus really going to be on values of small business? Here is a recent Barron’s article implying economic damage will get worse before it gets better.
- How quickly can closed businesses bounce back? Initial thoughts were that business will bounce back very quickly but that is seeming much more unlikely as the economy falters and the likely time periods for stay-at-home orders and the like looks longer.
- When will this lock-down end and recovery begin? One month, two months, three months?
- How much of a hit are operating businesses going to take to cash flows? Is this cash flow hit going to be merely timing as collections get deferred but paid, reduced revenues do to lower sales, or will work be delivered but then clients then are unable to pay?
- A liquidity crisis is brewing as the inability to pay debts and rents due to layoffs etc. increase. This will reduce payments throughout the economy even in industries not directly affected. It is unclear how this will impact other industries not directly affected and eventually the economy as a whole. A prime example of what is to come is the tremendous and quick reductions in tax revenues to state and local governments. These entities as a rule need to balance their budgets and budgets are collapsing. This will lead to deep cuts and payment issues. You can Google coming tax issues for your state and here is a link to a Pew Charitable Trust Article.
Discount rates and related capitalization rates and multipliers will need to be adjusted for the increased risk business investors face. The VIX index which measures implied volatility was in the 12 to 18 range in January 2020. It measured 66 on March 20, 2020. Click here to see the VIX chart. This indicates extreme uncertainty. Risk in business valuation and finance is the perceived likelihood that a financial return will not be received. The higher the risk the lower the value. Right now it is very difficult to estimate an appropriate discount rate or other risk rate.
Marketability discounts – Should additional marketability discounts be taken. Public stocks as a group are off by at least 30% from their highs. They can be liquidated quickly. Right now there are unlikely to be market buyers for private companies unless the buyer can “steal” something. The buyer’s rational is that is the only way to avoid insurmountable risk. The buyer may still get hurt if the company requires more cash infusions than planned to remain in business. This implies a marketability discount possibly in addition to an increased discount rate.
Business resiliency – most businesses in America are service businesses. How will reductions in force, layoffs, downsizing, and the like affect the ability of companies to restart and grow when this ends. How long will it take to retrain and get systems operating again. For most businesses their intellectual property (systems, specialized knowledge, customer quirks etc.) goes home every night and if it does not come back what will happen?
How will death affect the living – One thing that economists have not started looking at is how will the effect of 100,000, 200,000 or possibly a million deaths from coronavirus affect the living. Common sense says it will change habits and patterns but how? I live in central New Jersey. Death is getting very real here.
The net effect is uncertainty is off the chart and it is almost impossible to value a business with a valuation date of March 15, 2020 or later in most industries. Of course, in some cases business valuation professionals will have to do the impossible.
