Private Business Valuations in a Volatile Economic Outlook
By Dimitri Trianatafyllides, CFA
Over the last couple of years, starting with the pandemic-driven lockdowns in the spring of 2020, the global economy has witnessed both a shock and an immediate policy response by governments and central banks. The reverberations of COVID-19 case counts, fiscal stimulus, and Federal Reserve accommodation have all impacted the real economy as well as financial markets.
For business executives and owners of private companies, trying to establish a value for their own company in such a volatile environment can be quite challenging. Are current supply chain bottlenecks pressuring prices upward only temporarily, or is the tick up in inflation more permanent? Is currently depressed (or inflated) demand for a company’s products or services affecting its value? What if a company’s cost structure is currently out of whack? What if a company received PPP (Payroll Protection Program) loans that have since been forgiven? What if all capital spending products were temporarily eliminated? Currently, hiring good employees is really challenging. All these company-specific issues are typical concerns we hear from private company executives as it relates to their potential impact on the value of their company. Compounding these are external factors such as: Are interest rates likely to stay below inflation levels, or will they eventually increase above the rate of inflation? How does a private company’s value change if rates increase in conjunction with the public valuations changing as a result of continued accommodative monetary policy of the Federal Reserve?
In our independent valuation services, a collaboration between BRC and Sixty Guilders Management, we help private business executives and owners navigate these issues. We have helped executives value their businesses for various reasons including exploring strategic alternatives, mergers or acquisitions, profit sharing/ESOP valuation, tax audits, and inheritance/financial planning, among others. Herein we will try to address some valuation related concerns such as the ones listed above, but also share our methodology so that, even if we don’t address a specific concern, business owners may gain insight that will help them fit their concerns in one of our identified categories.
Before we address these issues more specifically, it will help to review the methodology of valuing a private business:
- The objective of an independent valuation is to estimate a company’s fair market value. The most commonly used definition of fair market value for valuation purposes is located in IRS Revenue Ruling 59-60. The IRS defines fair market value as “…the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.” (source: Trugman, Gary R). Clearly, in most merger scenarios, either the buyer or the seller initiates a dialogue. Therefore, it could be argued that the initiating party is more willing than the responding party. A valuation analysis must look through this and establish a fair market value regardless of the specific circumstances.
- A valuation is based on a range of external factors, and some may offset each other. For example, a private company’s peer group of public companies may be trading at a very high historic (or relative to other industries’) valuation multiple. However, this may be somewhat offset by the group’s trading volatility and correlation to the overall market, making the group riskier and increasing the discounts that must be applied to its valuation. Another example is inflation, which may help a company’s near-term profitability, but also implies an increasing cost of capital. As a result, the net impact on current valuation may be somewhat muted.
- A three-method valuation ensures volatile external factors don’t significantly affect a private market value. We deploy three distinct valuation methods to reach a valuation range for a private company, with the average presented as the single point estimate. The three methods are: 1) public peer group valuation analysis – looking at trading multiples of public companies competing in the same industry while comparing financial performance, ratios, growth rates and capitalization; 2) mergers and acquisitions – looking at purchases and sales of companies and comparing both the transaction multiples and financial data represented in each case; and 3) a dividend discount model that establishes a net present value of the company’s free cash flow based on the earnings outlook for the company and discounted using peer group beta and cost of capital assumptions.
Company specific issues such as the ones listed above can be thought of as affecting one of three financial categories: income generation, cash flow generation, or the balance sheet. When valuing a business, it is important to look through near term issues to ensure the business is valued for its intrinsic income generating capacity. For example, a company may have had recent operating losses, despite years of profitability, simply due to temporal external factors such as the ones mentioned above. A proper valuation will look through this near term “hiccup” and emphasize historic profitability as well as the company’s ability to return to a level of profitability in the future.
Balance sheet changes can also impact a valuation. For those companies receiving PPP funding (Payroll Protection Program) for example, business owners wanted to know the impact of these loans on their valuations. As long as it was reasonably expected that those loans would be forgiven, a business valuation estimate would disregard these funds from a company’s net debt claims.
Some companies experiencing high growth may have a large part of their valuation resting in future expectations. The valuation analysis must balance this outlook with the likelihood of execution. The implied higher volatility of potential outcomes and resulting higher discount rates serves as a counterbalance to potentially aggressive expectations.
Using the three different valuation methods above helps smooth out specific abnormalities that could otherwise impact a valuation, such as not having an ideal public peer group comparison or spotty transaction activity in mergers and acquisitions. Of the three valuation methods, the dividend discount model method may be the “purest” way to value a business, but it too is very sensitive to interest rate and cost of capital assumptions as well company-specific growth assumptions.
Please consult your business advisor if you have business valuation needs.