Risk and Return in the Market Approach
There are three main approaches to valuation: market approach, cost approach, and income approach. At ValuAnalytics, our primary focus is the market approach. The market approach is based on the principle of substitution, which assumes that an investor would pay no more for an asset than the cost of a comparable alternative. This concept applies to everyone in everyday life. In a simplistic example, the newest iPhone is priced at BestBuy at $1,000 while the same phone is for sale next door at Walmart for $900. The principle of substitution suggests that buyers, armed with full information on the product and pricing options, would opt for the discounted price. Why pay more than necessary?
The same principle is applied in the valuation of a business. Finding perfectly identical comparable companies to the subject privately-owned company being valued is highly unlikely. Therefore, an analysis is needed to compare the private subject company’s expected returns and risk to its closest peers traded in the public markets.
Application of the Market Approach
In the market approach, a company’s value is deduced using valuation multiples. Formulaically, valuation multiples are calculated as follows:
A valuation multiple is an indicator as to how much an investor is willing to pay per dollar of some financial metric of that company whether that be revenue, EBITDA, net income, etc. This is best illustrated in an example:
ABC Company has a value of $10 million. The company generates revenue of $5 million per year. The implied valuation multiple on revenue is 2.0x ($10 million ÷ $5 million = 2.0x). In other words, investors are willing to pay $2.00 for every $1.00 of revenue.
XYZ Company is identical to ABC Company in every respect except it is anticipated to generate lower future growth. The principal of substitution suggests that an investor would pay less for XYZ Company with lower growth prospects than ABC Company. In determining the valuation multiple appropriate to XYZ Company, an investor would likely apply a valuation multiple less than 2.0x (multiple for ABC Company).
In the real world, perfectly identical companies simply do not exist. This is because companies often strive to differentiate themselves in the marketplace, have management teams of contrasting quality, operate in different geographies, or have varying product focus, among a multitude of other factors. These differences result in a considerably more complicated analysis that considers both quantitative financial differences and qualitative variances between companies. While quantitative differences can be measured by analyzing financial statement information, the impact of qualitative considerations is notably more subjective. Qualitative factors can include customer concentration risk, history of meeting or missing projections, reliance on key members of management, or relative geographic or operational diversification, among many others. ValuAnalytics focuses on providing the quantitative component of this analysis.
Quantitative Analysis
The key quantitative factors that are typically considered in a business valuation are: size, growth, leverage, profitability, operational efficiency (turnover), and liquidity.
Size: Size is one of the more influential quantitative factors in assessing risk. Smaller companies generally have less resources to fund future growth, may have less depth in experienced executive management teams, are typically less geographically and operationally diversified, and are more susceptible to downturns. As a result, they are typically considered riskier than their larger counterparts.
Growth: The impact of growth on value is fairly intuitive. Companies with lower growth will generally provide lower returns, while companies with higher growth will generate higher returns. Typically, the higher the growth an asset provides, the higher its value. However, the impact of future growth must be considered in tandem with the risk of achieving that growth. Forecast risk can often be gauged by comparing future expectations to historical performance, as well as expectations against its peers. Forecasted growth that appears aggressive relative to historical financial results or the expectations of industry peers is often viewed as being riskier and would potentially reduce the positive impact of future growth on the asset valued.
Leverage: Effective use of financial leverage is an important consideration in any business. At the right levels, debt financing can reduce a company’s overall cost of capital and provide the funds needed to drive growth. At unsustainably high levels, leverage negatively impacts a company’s value via higher levels of financial risk to equity owners. A company with a heavy debt burden may have difficulty servicing that debt, effectively increasing default risk, and threatening the continuity of the business.
Profitability: Companies that generate higher levels of profitability will usually see higher valuations than companies with lower levels of profitability. Greater levels of profitability translate into higher returns for an investor and, concurrently, reduce susceptibility to downturns in the business.
Operational Efficiency: This factor is measured via a company’s turnover ratios, or a measure of how much revenue (or some other income statement metric) is generated from a company’s assets (or liabilities). Companies that can generate more income per dollar of assets are considered to be more efficiently run than companies that require more assets. In addition, companies are able to operate with less working capital when they can sell inventory faster, collect on their receivables faster, and/or maintain extended credit terms with vendors. A lower working capital position allows for less capital reinvestment in the business and more free cash flow (i.e., higher return). Thus, companies with greater operational efficiency with respect to their assets are generally favorable as compared to less efficient companies.
Liquidity: Liquidity represents a company’s ability to meet its short-term obligations. The greater the liquidity, the less financial risk (and higher the value) and vice versa. Important consideration should be given to how liquidity is generated, whether it be through profitable operations, recent funding via debt or additional equity, etc.
Each factor is important to assess risk and return of a company and provides a strong starting point for selecting valuation multiples. The comparison of financial ratios alone, however, is not adequate to determine a company’s value. Facts and circumstances unique to the company being valued are equally important in deriving a supported valuation.
ValuAnalytics provides the comparative quantitative analytics needed to supplement your internal valuation and analytical processes and generate a stronger, more supported conclusion. Request our analytics or use the contact box to request a consultation.