How is value determined?
An entity is valued by determining the economic benefits created by the business. Economic benefits in this instance are increases in company resources from inflows of cash or increases in assets. This is primarily done by either discounting a benefit stream to a present value or capitalizing a benefit stream. The discount or capitalization rate is determined by estimating what kind of return an investor would demand from the investment in the business. For instance, an investor would require a greater return from a riskier investment, as a riskier investment has a higher likelihood of loss. A higher return compensates the investor for the added risk. To highlight this let’s ask the question which would you pay more money for a company that has a 50% chance of earning $100,000 and a 50% chance to lose your investment, or a 95% guarantee that an investment would pay out $100,000 in the next year. I think it is safe to say that a rational investor would pay more for a better guarantee. The simple calculation illustrates a possible investment that one might make for three different Scenarios.
| Scenario #1 | Scenario #2 | Scenario #3 | |||
| 50% likelihood of return of $100,000 | 95% guarantee or return of $100,000 | $100,000 20 year US Bond | |||
| Risk free rate | 4.83% | 4.83% | 4.83% | ||
| Investment risk rate | 50.00% | 5.00% | 0.00% | ||
| Combined rate | 54.83% | 9.83% | 4.83% | ||
| Rational investment | 45,170 | 90,170 | 95,170 |
These demonstrate varying levels of risk and the impact of the risk on the investment value. They emphasize the importance of assessing the risk, which is essential in consideration of real-world business valuation
In these scenarios you can see how one might consider how much they are willing to invest in a security. The way it is calculated it adds the risk-free rate to the investment risk rate. The investment risk rate is determined in this example by taking the probability that the investment would not pay out. Something not considered in this example is competition, but it illustrates how risk affects value.
Now we know that value is derived from discounting or capitalizing a benefit stream, now how do you increase value?
To grow the value of a business there are two primary ways. 1.) Increase the benefits provided by the company and 2.) reduce the risk that those streams of benefits will continue in perpetuity. In this article benefits represent the inflows of resources from the operations of the business after operation expenses.
The increase in inflows into is a very obvious way to increase the value as a higher return on investment obviously increases the end value. Something not considered by a lot of business owner/operators is reducing the risk of the entity.
So, what affects risk? Some examples include:
- Regulations – Legal or compliance requirements
- Competition – Market barriers, market saturation
- Complexity – Challenging operations
- Staffing issues – Difficulty retaining and finding qualified employees
- Lack of automation – Manual processes increase the likelihood of errors
- Key employees – Dependance on individuals for operation
- Economic impacts – Location specific factors
- Operational procedures and policies – reliance on staff memory and discretion to operate
How can these items affect risk? Consider if the business operates in a highly regulated industry where transgressions of laws could lead to fines, or the operation being shut down. On the flip side if the company has mitigating controls that other competitors do not have could create a premium. If the barrier to entry is significant, this could limit competition which could limit the risk of competition taking market share. The complexity of operations could make it difficult to find staff or create an opportunity for errors or mistakes.
A way to increase the value without increasing the bottom line is to address these areas to mitigate any risk that may be inherent in these or other areas of the company.
How much does changing the risk profile of your company increase value? Consider a company that has $100,000 in net income annually with a 2% discount rate from 20% to 22% there is a $45,000 difference in value from $500,000 @ 20% to $454,545 @ 22%.
Not only does reducing risk increase the value of the investor, it will likely have a positive impact on the bottom line as well form improved operations. Due to this fact it is important to mitigate risk in your operation. Without a trusted advisor guiding efforts to raise value business could be leaving a significant amount of money on the table. An advisor can bring expertise in areas such as financial analysis, risk assessment, operational efficiency, and trends in the market. By utilizing their knowledge, business can increase their value through reduction of risk and make informed decisions.
