Current economic volatility — as evidenced by rising costs, upticks in interest rates, bank failures and geopolitical risks — adds an element of uncertainty when estimating business value. So, even established businesses can’t necessarily count on historical profit margins and capital costs. This article discusses some ways valuators may adapt their analyses to account for uncertain market conditions. 

Income approach

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 

• Sales of private or public companies under the guideline transaction (merger and acquisition) method, or 
• Publicly traded stocks under the guideline public company method. 

Pricing multiples — such as price-to-pretax earnings or price-to-revenue — may be applied to the subject company’s historical financial metrics. However, when market conditions are unstable, it may be appropriate to analyze only recent comparables. Additionally, valuators might make adjustments to pricing multiples to account for current market conditions or use forward-looking pricing multiples to apply to the subject company’s projected financial results.

Cost approach  

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 there’s economic uncertainty, it’s important for attorneys and business owners to carefully review business valuations. You should make sure your valuator takes steps to incorporate economic factors into his or her analysis. Note: Valuations shouldn’t be recycled for unintended purposes, because a value that’s accurate today may be inaccurate in a few months. Contact us here if you have any questions.