6.2 Influences on the value of an enterprise – risks
With an understanding of the basics of the capitalized cashflows valuation method, a business owner will have several clues regarding the main influences on enterprise value. This article looks briefly at the way the various risks faced by the business influence its value. In valuation terms, this could be considered a “bottom-line” issue.
Remember, the value of an enterprise can be reduced to a single equation: Value = Opportunity / Risk
A low-risk business will always be worth more than an otherwise equal high-risk business.
In considering what capitalization rate to use, a CBV is really considering a reasonable required return on an investment in the business. The required yield is very largely a function of the riskiness of the business, and specifically the riskiness of the business when compared to a publicly traded company in the same industry (note that in most cases an investment in a public company is liquid, the shares can be sold quickly. It is considerably more difficult to dispose of an ownership position in a private business).
Some of the most common issues that a CBV will consider regarding the risks in an enterprise are:
- Systems that allow the business to operate well – small businesses usually have more challenges with systems than large companies. Many valuators will apply a “size” premium to cater for this risk.
- Dependencies – analyzing a business’s operations will usually show what, or who, it is overly dependent on. It could be a dependency on the owner-manager, or a product or service or customer or supplier, or a specific law. The questions to be asked are:
- how badly would cashflows be impacted if this person/product etc were lost to the business?
- what is the likelihood that this loss could occur?
- Continuity of income and profits: this can be influenced by many issues, some referred to above, some driven by the general economic environment, and yet others that are specific to the business. An ability to withstand tough times will usually enhance the value of a business.
- Ability to borrow – if a business has a strong ability to borrow, it will likely be able to significantly reduce its WACC by accessing loan capital at a lower cost than equity capital.
Contact MVI to discuss the influence of earnings and risks faced by your business on its enterprise value.