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

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

Attractive Acquisition Attributes – Part One, Consistency

“Slow and Steady Wins” – I saw this slogan on a tee-shirt recently and realized how true it was when related to what makes an attractive acquisition target.  Stated another way, we are talking about steady, consistency in any number of business metrics that a potential purchaser might consider.

Since valuation is predominantly driven by earnings, let’s begin by looking at consistency of earnings.  At times, we have clients come to us ready to go to market because they have finally had that gang-buster year they have been waiting for.  Revenues are up 50% and earnings are up 60% and everything looks great for the future.  Unfortunately when we pull back the curtain and look at the long-term trends, earnings have been volatile even when there has been a long-term positive trend.  It is always better to go to market when you are coming off of a good year but buyers look at more than one year and tend to average out the up years with the down years.


Volatility, risk and value are undeniably linked.  I have a favorite saying, “Buyers purchase the future but pay for the past.”  What I mean by this is that Buyers purchase a company for what they expect they can do with the company in the future but they set the price based on past performance, not based on some optimistic forecast, which may be based on one good year.  So where does risk come in?  When we market a business, we present a forecast to prospective buyers.  These forecasts are largely based on past performance but tend to represent some level of straight-line (consistent) growth in to the future.  If this nice consistent, straight-line forecast is based on historical numbers that are volatile rather than smooth and consistent, then the risk for the purchaser of achieving the forecast is higher.  Higher risk equal lower valuation when the buyer tries to determine a purchase price.  So “slow and steady” (consistent) earnings are much more valuable than one great year.

There are other areas where consistency can add to the overall value of a company.  Consistency in management show stability and continuity and lowers the risk to a purchaser.  Consistency in the customer basis (if repeat business is a normal part of your business model) demonstrates stability and lowers risk.  Similarly, consistency in a company’s supplier basis shows stability and can positively impact value.  Even consistency in the presentation of financial information (financial statements) reflects stability and will make a business more attractive to purchasers and therefore more valuable.

“Slow and Steady” is not necessarily sexy or exciting but given the choice of representing a company that has slow and steady earnings vs. one that has volatile earnings; even if the average earnings over a five year period for both are identical, Slow and Steady Wins every time.

Alan D. Austin, CFA