By Eric Larson
November 20, 2008
The stock market seems like it is in free fall for days. There are reports of significant job losses and mounting unemployment. Expectations for corporate profits in the coming quarters are being reduced. Large firms in many industries seem to be in a very perilous situation. Banks are hurting and don’t appear to be lending money to anymore. These are just a few of the economic realities we are hit with on a daily basis lately.
While performing the analysis to determine the value of a business, part of the exercise is to examine the current economic environment. The reason for this is to determine the potential impact of current economic trends on the value of a company. The current economic environment has caused many people to ask me, “What is this going to do to the value of my business?” The simple answer, generally speaking, is that it is likely going to come down. There are several reasons.
First, the value of a business is based primarily on expectations. The value of a business under an income approach is based on the risk-weighted future returns of the company. If the economic conditions are pointing to soft sales, increasing pricing pressures or increasing costs, profits and cash flows are likely to decrease. If profits and cash flows decrease, the company’s value will likely decrease.
Businesses are also valued based on comparison to their public and private company counterparts. As we have all seen recently, the stock markets have been taking a beating. Investors’ expectations are for lower profits, so they have discounted the prices accordingly. Lower valuation multiples for these guideline companies will produce lower values for the subject company.
Another factor is related to general risk and uncertainty. Businesses that may have a high concentration in troubled industries may pose a higher risk than they did a short while ago. In addition, companies in industries that are capital intensive and utilize debt will likely find lending standards significantly more stringent. The general economic uncertainty also raises the cost of capital for businesses. All of these factors, and others, produce higher risk. Higher risk means higher returns are desired by investors. And these higher return expectations translate into lower capitalization rates, valuation multiples and values.
Compounding some of the downward pressures on business values is the lending environment. A company may be in good financial condition with stable or growing revenues, but may be unable to find buyers due to limited capital available. Many lending institutions have significantly tightened up and generally seem unwilling to lend to customers in some industries. This lack of credit limits the potential pool of investors and also drives prices downwards.
It was mentioned previously that generally speaking business values will likely decline. However, there are certainly exceptions. There are companies that are in industries that are counter-cyclical or are in industries that have strong growth expectations in spite of the current economic environment. While the pressures noted above may have some impact, strong companies in growth industries, companies with niche products or in niche industries may likely see values continue to rise - although it may be at a lower rate than in recent history.
The best things for all business owners to do at this time are to continue to focus on gaining market share, as the market may be declining overall. Focusing on internal costs and becoming more efficient is also key. Strengthening the company’s balance sheet will provide long-term strength to the company. These and other actions will help keep the company going through the tough times and put it in position to see strong growth when the economy recovers. And that will lead to even higher value down the road.
Eric J. Larson, CPA/ABV, ASA, CBA, CMA, is senior manager for business valuation for Beene Garter, LLP. He has extensive practical experience in the field of valuation, transaction negotiation, merger and acquisition representation and corporate financial planning. He can be contacted at [email protected].