Tuesday, February 21, 2017

Low Risk is the Key to Valuation - Part One

In this two part article we will discuss what really drives business value and what a business owner can do to impact their value when they ultimately sell their business.

For many business owners, business value is a multiple of adjusted EBITDA (earnings before interest, taxes, depreciation and amortization).  At a fundamental level that is a correct assessment.  Purchasers buy cash flow and are willing to pay a reasonable price based on the risk associated with the continuation of that cash flow (EBITDA).  So the logical next question is "what multiple should be used?"  The multiple is an indication of the risk to the purchaser in purchasing the business' cash flow.  Whenever any of us make any investment, we hope to earn a return that is commensurate with the risk of that investment. The business purchaser is no different.  The higher the risk the lower the value and vice-versa.

So, how is a multiple an indication of the risk associated with purchasing a specific business and its related cash flow?  Not to get to mathematical here, but multiples are simply a convenient way of expressing the actual rate of return required to entice a purchaser to acquire the business; the return commensurate with the risk.  In business valuations we call this the Capitalization Rate.  For example a four (4) multiple is the inverse of the rate of return or 25% (1/4, the inverse of 4).  Similarly a five (5) multiple (the inverse is 1/5) is 20%.  A lower risk, as represented by the 20% required return, produces a higher value (5 times) than the higher risk represented by the 25% return (4 times).  In a separate article we will discuss how we develop the appropriate multiple for a specific business.

If risk is the primary driver in establishing value and more specifically if lower risk leads to higher value what are the factors that reduce the risk to the purchaser in acquiring a specific business and its related cash flow?  Stated another way, purchasers want to acquire a business where there is a high degree of confidence that the cash flow will continue on an uninterrupted basis; low risk.  At the fundamental level purchasers want to purchase consistent, diversified, recurring cash flow.  In part two of this two part article we will explore some of the specific factors that can lower risk.

Alan D. Austin, CFA
Graham Patterson

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