We have all heard the expression “the greater the risk the greater the reward”. The adage remains true when considering the value of a company. The value of a business is impacted by the amount of risk involved in receiving a future reward. As with all investment decisions, the risk-to-reward tradeoff must be measured. In general, the greater the risk, the lower the current value (and therefore greater future reward) is in the eyes of a potential new owner.
In most operating companies the benefit (or future reward), along with the company’s value, is tied directly to the net cash flows expected to be received from future sales of products or services. When appraising the value of the business, the appraiser needs to consider the risk to this future cash flow. A business may be producing significant current income for its owners, but the question is what will happen to those income levels in the future?
Appraisers need to consider the risk to the industry in which a business operates. Think about industries with services like printing and newspapers, telephone operators and gas station attendants. These industries may have had huge returns in the past; however, if demands decrease in the future, business value may be significantly impaired.
Let’s assume the business is in a thriving industry which is expected to continue into the future; an appraiser will want to look at cash flows in the past. Of course, past performance is no guarantee of future results, but it is a good place to start. An appraiser may generally look at the past three to seven years of performance to gain an understanding of where the company is in the business life cycle, identify trends, and generate expectations for the future.
If the company does not have a proven track record of cash flow to owners, then the future value is likely to have more risk than an alternate company with this history. Startups or new businesses that have no record of a benefit to the owners could be considered an uncertain investment. Without the benefit of hindsight, an appraiser would need to work with management and industry experts to forecast future cash flow.
Once an appraiser has appropriately considered the future expected benefit (cash flows) of an operating company, then it is important to consider other factors involved to determine the amount of inherent risk. Risks to geography and general market conditions need to be considered.
Business value is correlated to an anticipated future cash flow, and as such, it is discounted to the present value at the cost of capital. The cost of capital discount is an opportunity cost, or loss of potential for an alternative investment. The discount represents a quantification of the associated risk to future cash flows, as discussed above.