Preface: Selling a privately held business requires, time, effort, and cost to initially locate a bidder through to finalizing a successful transaction. The liquidity of the investment is a key attribute that reflects the value premium with an applicable discount.
Profitability and Business Valuation: Appraisals Are a Prophecy of an Enterprise’s Future Cash Flow Value (Segment III)
Credit: Donald J. Sauder, CPA | CVA
What is a Right Rate of Return?
At the heart of all business valuations is a marketplace rate of return on a business “investment”. This is often either a mathematical divisor or a multiplier. If you are investing in a bank certificate of deposit, rates vary from bank to bank. So likewise do dividend rates from business to business, and net earnings also fluctuate. For instance, if you invest in dividend stocks, what is your expected rate of return on the investment? Always, the higher the risk, the higher the rate of investment return on that asset. Managing the entire chess board of investment rates of return, (a.k.a. investment yields) is the Federal Reserve in the United States.
When an assessment of value is generated on a business, immediately generated is a correlating assumption as to how the credit markets will provide liquidity both for investors and consumers in the future. Liquidity and velocity of money are indicators to economic stability.
Correspondingly, in stable economic conditions, business valuations are higher than in recession conditions. This difference includes, among a multitude of factors, the access to credit for buyers, purchasing power of customers, and the effective rate of return on the investment in that higher risk business environment.
Higher investment rates of return result in lower business value, and lower rates of return result in higher business value because of the investment yield on the business assets. Determining the appropriate rate of return on a business is the work of financial market participants. For instance, valuations can sometimes use an addend approach for a capitalization factor, such as a risk-free rate e.g., Treasury bonds, adding on an equity risk premium rate, with a size premium rate addition, and then frost an industry and company risk premium rate for a summed market rate of return on the investment.
Capitalization rates when they are multiples are a certain percentage. For instance, a three-times multiple is essentially a 33% rate or return for the investment, and a four-times multiple is a 25% rate return. The rate is obtained when dividing one with the multiple. So, a 20% capitalization rate is a five-times multiple of cash flows.
Normalized net income, EBITA, or operating cash flows, and tax effective adjustments and extraordinary earnings or expenses are all part of valuation. Yet appropriate capitalization rates on those earnings can lead to many varying opinions among business valuators.
What about Buyer Discounts?
One precisely misunderstood feature of business valuation is necessary and reasonable discounts for lack of marketability and lack of control or minority interests. Simply capitalizing normalized earnings is not the final value of a business. Too often overlooked among entrepreneurs, there are substantial differences between business ownership of a publicly traded business and that of a private enterprise as an investment. Selling a privately held business requires, time, effort, and cost to initially locate a bidder through to finalizing a successful transaction. The liquidity of the investment is a key attribute that reflects the value premium with an applicable discount.
When valuing a business with a potential and ready buyer, it does not change a fair market value of an enterprise. Fair market value is the price at which two bidders would agree to both purchase the business. When you bid on an asset at an auction, the final bid is not fair market value. It is the second to last bid supposedly because you could immediately sell the purchase for that price in the marketplace. Only you bid that final sales price for an auction asset, and therefore, the asset doesn’t hold that value to any other marketplace participants, other than to your final bid. Does the highest bidder always win?