A business’s value is driven by two key components: Cash Flow and Risk.
The more risk that exists, the less value a company has and vice versa.
How Is Risk Determined?
Risk rating a company is identifying its strengths and weaknesses by considering several common risk factors or “Critical Value Drivers”. These risk factors include: Financial Risk, Quality of Financial Information, Diversification Risk, Management Risk, Industry Risk, and Competition Risk.
A company’s financial risk is primarily based on its consistency and overall performance from a financial perspective. Erratic, inconsistent and below industry average financial performance warrants the higher risk. Consistency and performance above industry averages warrant the lower risk.
Quality of Financial Information
The quality of a company’s financial information is based on the analyst’s confidence level in the accuracy of the financial statements. For instance, a CPA Audited Financial Statement would have a much lower risk when compared to a company’s internally generated financial statement. There could also be a risk in the reliance upon an interim statement.
Diversification risk is based on (1) diversification of customers (reliance upon 1 or 2 main customers); (2) diversification of suppliers (reliance upon a single supplier); (3) product or service mix diversification (reliance upon a sole product or service); and (4) geographic diversification (significant reliance upon location). The more the customer, supplier, product and geographical diversification a company has the lower the risk and vice versa.
Management risk is the reliance upon the current owner(s) of the business and/or key management or another key employee. For instance, the more specialized a professional practice or business, the more likely that business will be reliant upon its owner. A great example of a management risk is a dental practice which relies upon the named dentist for its success. This would result in a higher management risk.
Industry trends can impact a business valuation on a number of levels. Even if industry trends are “positive” at the date of valuation, if the company is highly influenced by the industry, the risk could be above average to high. If the company has performed well and doesn’t appear to be impacted by industry trends, the industry risk may be considered low.
If the business is dependent upon its location, it most likely has a high competition risk. Businesses with higher barriers to entry can sometimes have a lower risk of competition. Just because a business has no competition, does not mean there is “low” competition risk. What’s the likelihood of a new competitor entering the market?
Cash Flow and Determining the CAP Rate
The above risk factors are taken into consideration and a “Build Up” capitalization and discount rate are calculated. The cap rate provides a required return to the shareholder, which is applied to cash flow to determine value. For instance, $250,000 divided by a 25% cap rate would equal $1 million. Another way to achieve this is to invert the cap rate into a multiple, or 1 divided by 25% which equals 4x. $250,000 x 4 = $1 million.
Banker Valuation helps users calculate both cash flow AND the cash flow rate (multiple) accurately and correctly. Our internal valuation tool for lenders analyzes and compares businesses to similar businesses in its industry. Banker Valuation created this to isolate the “Critical Value Drivers” in most small businesses to more accurately assess a company’s risk.