In times of economic volatility, valuing a business can become a complex process, especially when the business is in flux. Rising costs, fluctuating interest rates, and geopolitical risks are just a few of the factors creating uncertainty, even for established companies. This article explores how valuation experts can adjust their methods to account for these challenging conditions and offer more accurate estimates.

Income Approach: Adapting to a Business in Flux

Under the income approach, value is based on expected future earnings (usually cash flows), which are then discounted to their present value. When market conditions are stable, historical financial statements are typically used to estimate future earnings. However, if a company’s performance is expected to differ from previous periods, a valuator can’t necessarily rely on historical data. Some changes in business operations may be only temporary, but others could continue indefinitely.

Short-lived changes may necessitate the use of a more complicated discounted cash flow analysis over a simpler capitalization of earnings method that’s based on expected cash flows from a single period. Some changes will continue indefinitely, however. When considering a business’s expected cash flows, a valuator must look at current sustainable cash flows. Valuators also may use more sophisticated assumptions to develop expected earnings projections.

Likewise, experts typically use discount rates that reflect the risks associated with the operating environment on the valuation date. Commercial interest rates have increased significantly in recent years. In addition, market and company-specific risks have intensified, which may increase a business’s cost of equity. Many companies are currently experiencing labor shortages, rising prices from suppliers, exposure to cyber risks, and increased state and federal regulations. Investors generally demand a higher return to compensate for the added risk of operating in an uncertain environment, which usually decreases value. 

Market Approach: Adjusting for Current Conditions 

The market approach derives value from pricing multiples based on comparable business sales or ownership interests. When valuing a business in flux, it’s crucial to adjust pricing multiples to reflect recent market data. For instance, valuators might rely more heavily on recent comparable transactions or use forward-looking pricing multiples if they anticipate significant fluctuations in performance.

This approach involves two primary methods:

• Guideline Transaction Method: Considers recent sales of private or public companies in similar sectors.
• Guideline Public Company Method: Uses publicly traded stock comparisons.

Pricing multiples like price-to-earnings or price-to-revenue can be applied, but it may be necessary to fine-tune these multiples to reflect current market uncertainties when valuing a business facing fluctuating conditions.

Cost Approach: Providing a Value Floor  

The concept underlying the cost (or asset) approach is that the value of a business equals the difference between the values of its assets and liabilities. Each item is valued using either the income, market or cost approach. Historical balance sheets are often the starting point for this valuation technique. However, balance sheets prepared under U.S. Generally Accepted Accounting Principles usually don’t include intangible assets (such as brands, customer lists and goodwill) and contingent liabilities (such as pending litigation or an IRS audit). 

The result may serve as a “floor” for a company’s value or sanity check to compare to the results of the income and market approaches. After all, reasonable sellers typically won’t accept less than net asset value in a merger or acquisition unless they’re under duress to sell. In uncertain economic times, the cost approach may become increasingly relevant, particularly for distressed or insolvent businesses that aren’t generating sufficient earnings to contribute to business value.  

Exercise Caution When Valuing a Business in Flux

In volatile markets, both attorneys and business owners should approach valuations carefully. A business valuation that’s accurate today could be outdated in a few months if economic conditions change. It’s essential to confirm that your valuator has fully accounted for market fluctuations and other relevant factors impacting the value of a business in flux.

Valuations prepared without regard to current market conditions can mislead decision-makers and stakeholders. Contact our team today if you have questions about valuing a business during uncertain times. Our experts can provide tailored insights to help you understand your business's true worth, even in a fluctuating environment.