When conducting a company valuation, there are a number of factors that influence the company’s ultimate worth. A larger sized company, for example, is often predicted to be more profitable, and therefore have a higher value.
While this is generally a good rule of thumb, business values are not always absolute. Two key elements go into determining business value: how you measure business value and under which circumstances. While companies with higher sales seem to be more profitable, the fact is that large and small companies operate on different scales.
The average person perceives data in a very skewed manner. A Reason-Rupe/Yahoo! survey, found that American citizens believe the average profit margins of U.S. companies are around 36%. Walmart, one of the nation’s largest companies, has a profit margin of only 3%, while those of most other large businesses are about 7%.
If a large company that earns more than $5 million in revenues has an average profit margin of 7%, but the company that earns less than $1 million has a 15% profit margin, one could say that the smaller company is more successful.
The income of a larger company is certainly more steady and predictable, but small business valuations may prove to demonstrate higher returns and growth than those of large companies.
Smaller companies have a far higher risk. Investors expect a much greater return from small companies. However, large companies can get away with smaller returns, as they tend to be more consistent.
This is partly due to the fact that large companies like Walmart have a vast amount of resources and are diversified in their products, and can therefore play a profitable part in a number of markets. Small companies often cater to niche markets, and don’t have as many opportunities to branch out.
The discount rate is one of the key indicators of company value during a business valuation appraisal. When calculating the discount rate, the greatest gift is a low premium. Because the company size premium is in the denominator of the business valuation calculation, the business value is lower with a high premium.
Smaller companies have inherently high premiums due to their higher level of risk, which can severely impact a business valuation appraisal. If two companies operate within the same business sector and each earn $1 million in capitalized earnings, the large company’s value will still be higher.