The 7 basic principles of business valuation : Principle 3

The 7 basic principles of business valuation : Principle 3

Principle #3:  While market rates of return are constantly in a state of flux, they provide important benchmark indicators at any given point in time, and over the long term influence rates of return sought by individual corporate acquirers.

When establishing the value of a business using an income-based technique, the value of the business will depend, among other things, on the rate of return that will be assigned to it by the appraiser. To simplify the calculation, one divided by the rate of return becomes the multiple that is applied to the maintainable earnings, for example, to have the operational value.

The time spent by the chartered business valuator (“CBV”) to determine the rate of return depends on the type of report that will be requested by the client. For a calculation of value report, the CBV will make a more summary analysis of the rate. For a comprehensive valuation report, the analysis will be further developed.

The most common approach is the built up approach. As the name suggests, this method involves using the risk-free rate of return as a basis. We then add several layers of risk (factors), to finally have the return requested for the business evaluated. The main factors can be separated in 5 main factors.

Factor 1 – Risk-free rate

This rate represents the risk-free rate of return. We usually use an investment such as a Canadian bond as a measure of the risk-free rate measure. Interest rates have an influence on this rate.

Factor 2 – Risk premium on the equity of public companies

Then, the historical rate of return on the equity of public companies exceeding the return on government bonds available on the valuation date is used as a measure of the rate of return.

Factor 3 – Industry risk

The rate of return is then adjusted according to the industry in which the business operates. The industry can have a very strong influence on the rate of return and that can be explained by the following factors: the sensitivity of fluctuations of the industry to the general economy, regulation, rationalization, competition, technological development in the industry, labor and trade unions, political circumstances, and many other factors that may be industry-specific that need to be addressed. Depending on the industry risk, the investment risk will be higher or lower.

Factor 4 – Risk premium for the size of the business

After the market, the CBV considers the size of the business, given that, depending on its size, certain factors may influence investment risks such as its influence on the market, its share in the market , the possibility of economies of scale and the difficulty of obtaining financing. A business that has a good market share will have less risk than a business that owns only a small portion.

Factor 5 – Specific Risk

The CBV ultimately adjusts risks to the business itself; more specific risks allowing the distinction between a public company and a private business. The following factors are commonly used: diversification of customers and suppliers, product life cycle, competitive advantages / disadvantages, managers, product demand and labor. It is important to evaluate these factors by comparing them with the rest of the industry since each sector may have specificities related to the industry in which the business operates. An adjustment can be made at this level or separately, whether the business being assessed is easy to sell or not. We are talking here about liquidity. For example, it is more difficult to sell shares of a private business than those of a public company.

Example: Rate of return = risk-free rate

+ Risk premium on the equity of public companies
± Industry Risk
+ Risk premium related to the size of the business
± Specific risk (including adjustment for illiquidity, if applicable)

By adding the factors listed above, the CBV calculates the rate of return for the business that will be used in its assessment. It should be noted that comparisons with the rest of the industry and the market are important. Indeed, two businesses of the same size, in the same industry, may have very different rates of return depending on the factors mentioned.

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