Low Risk is the Key to Valuation - Part Two

In part one of this two part article on business valuation we explained how the risk associated with the consistency of the acquired business' cash flow is the primary driver in establishing the business' value.  As we stated in the part one, purchasers want to acquire a business where there is a high degree of confidence that the cash flow will continue on an uninterrupted basis; in other words, low risk.  When the purchaser perceives a higher risk associated with the continuation of the historical cash flow of the business they respond with a lower price.

If lower risk is the key, let's explore some specific factors that can lower the perceived risk associated with the  continuation of the business' cash flow, post-sale.  Below are some of the factors that can impact this perceived risk:

Consistency - Generally, consistent positive trends in all business metrics and more specifically in revenue and earnings is probably the single most important factor in reducing risk to a purchaser.  Based on consistent positive trends, they will be comfortable that the earnings capacity of the business will continue after the purchase.

Management - Businesses that have a management team as opposed to an owner who runs the day-to-day operations of the company will be perceived as less risky.  Having a management team in place that can continue to run the daily operations after the sale, reduces the risk that earnings will decline after the sale.  It also opens the door to financial purchasers who want to buy companies with a management team in place.

Diversification - A diversified customer base; diversified supplier network; and a diversified product line, just to name a few, all reduce the risk of the business purchase for the purchaser.  Frequently described in its converse as concentration, purchasers are always interested in understanding if revenues or earnings are concentrated with only a few customers.  Likewise, they want to make sure there are adequate sources for critical raw materials or supplies. 

Asset Quality - The age and quality of the asset base can be a factor in evaluating acquisition risk.  A relatively new asset base that is well maintained communicates a culture of continuous reinvestment and attention to maintaining quality.  

Size - This is somewhat intuitive but larger companies tend to command a higher multiple simply because of their larger size.  This is because larger companies are perceived to be better able to withstand competitive pressures or financial challenges that may arise from time to time. 

Commodity vs. Value-Added Products - Clearly there is a place in the world for companies that produce commodity products.  Generally these types of companies have to differentiate themselves based on efficiency, quality and price.  Having acknowledged that, there is the perception that a company that has a proprietary process or produce is less risky to a purchaser.

This is not a complete list but it serves to illustrate some of the factors that can reduce the perceived risk for a purchaser, lower the capitalization rate and therefore increase value.  None of these items are absolutes but to the extent a business owner can develop some of these characteristics in the years leading up to a sale, it will surely add to their overall enterprise value.

Alan D. Austin, CFA
Graham Patterson