The Importance of Business Valuation

I. Introduction

a. Definition of Business Valuation

Business valuation is the process of determining the economic value of a business or asset.

It measures what the business is worth in terms of the present value of its expected future cash flows. Business valuation involves analyzing financial statements, assessing the value of assets and liabilities, and considering a range of other factors such as industry trends, the competitive environment, and economic conditions. It is a necessary step in mergers and acquisitions and is used for tax, legal, and financial reporting purposes.

b. Overview of the importance of business valuation

Business valuation is an important tool used to determine the economic value of a business. It is used by investors, lenders, and owners to help make informed decisions about the business. It is also important for tax purposes, as it helps determine the fair market value of the business for tax purposes. Business valuation can also be used to assess the potential sale value of the business. Finally, it can be used to help determine the best pricing strategy for the business.

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II. Reasons for Business Valuation

a. To determine the value of a business

b. To assess the financial health of a business

c. To determine the fair market value of a business

d. To assess the potential of a business

III. Types of Business Valuation

a. Asset-based Valuation

The asset-based valuation approach is a method of valuation that considers the value of a company based on the value of its assets. This approach is commonly used to value companies whose assets are tangible, such as real estate, manufacturing plants, or equipment. This approach looks at the physical assets of a company and values them based on their fair market value. The asset-based valuation approach can provide a useful measure of a company's worth, but it may not always be the most accurate method of valuation. It is important to consider other factors, such as a company's earnings and potential for growth, when making a determination of value.

b. Market-based Valuation

The market-based valuation approach is based on the principle that the value of a business is equal to the sum of the values of its individual assets. This method looks at how much the company is worth by comparing it to similar companies on the market and taking into account both its tangible and intangible assets. This approach may also include an analysis of the company's financial performance, its competitive advantages, and its overall position in the market. This approach is generally used when a company is looking to sell or purchase another business.

c. Income-based Valuation

Income-based valuation is a method of valuing a business or asset based on its income. It is based on the theory that the value of an asset is equal to the present value of its future cash flows. This type of valuation is commonly used for stocks, bonds, real estate, and businesses. It is an important tool for investors, as it can help them determine the potential return on their investment. In addition, income-based valuations can also be used to compare different investments and assess their relative value.

IV. Benefits of Business Valuation

a. Helps in making informed decisions

b. Helps in setting realistic goals

c. Helps in determining the right price for a business

V. Conclusion

a. Summary of the importance of business valuation

Business valuation is important for a variety of reasons. It can help a business owner determine the fair market value of the business and provide information that can be used to make more informed decisions. It can also provide insight into potential investments, mergers and acquisitions, and other strategic decisions. Valuations can also be used to help resolve disputes or in the event of bankruptcy or dissolution. Finally, they can provide evidence of the value of an owner's equity in the business.

b. Final thoughts on the importance of business valuation

For business owners, potential buyers, lenders, and investors to determine the worth of a company or its assets, business valuation is a crucial tool. It assists in guiding choices regarding whether to seize a business opportunity, make an investment in a business, or buy an already-existing company. A valuation can also serve as a foundation for other decisions, such as determining the loan's value or estimating a company's value for tax purposes. Decision-makers can greatly benefit from the use of business valuation as a tool to better understand the value of a company and make wise choices

The Washington Valuation Group

The Impact of Inflation on Business Valuation

By Achille Ekeu, MBA, CVA

U.S. Inflation

Calculated annually, the U.S. Inflation Rate reflects the average percentage by which the price of a specific basket of goods and services purchased in the United States has increased. The U.S. Federal Reserve uses the inflation rate as a key indicator of economic growth and stability. The Federal Reserve has been monitoring the U.S. economy’s inflation rate since 2012, and if it is higher than 2 percent, it may alter monetary policy. Inflation spiked dramatically in the early 1980s when the economy was in a deep recession. When inflation reached 14.93 percent, the Federal Reserve under Paul Volcker had to take drastic measures.

The current rate of inflation in the United States, as of October 31, 2022, is 7.75 percent. This is a slight decrease from the 8.26 percent rate recorded in September 2022.

Source: YCharts—U.S. inflation Rate[1] Information retrieved December 6, 2022, from https://bit.ly/3NiIFPZ

Effect of Inflation on Consumers

The effects of inflation on consumers’ spending and psyche are well-known. The difficulties it causes in day-to-day life are often discussed. Inflation has affected everything from the cost of transportation to the cost of food and housing. What is less discussed, however, is how the current inflationary period is affecting small business owners and their companies. If you have clients who are business owners, you have probably fielded questions from them about how to protect their operations from the current economic climate. More than 1,500 small business owners were surveyed, and an overwhelming majority cited inflation as their primary concern. When asked to choose between inflation, labor quality, regulations, and tax rates, 34 percent voted for inflation.

Source: Biz-Equity—Inflation[2] Information retrieved December 6, 2022, from https://bit.ly/3h5OEfy

The Impact of Inflation on Business Valuation

There are three value drivers that impact the value of a company: a) the cash flow, b) the growth, and c) the risk. Simply put, Value = Cash Flow(1+g)/Risk. Now, to measure the impact of inflation on business valuation, we need to analyze the impact of inflation on these three value drivers.

a) Impact of Inflation on Cash Flow

Valuation experts typically use cash flow as their primary metric of economic benefits. So, how does inflation affect cash flow? The general rule is that when inflation is high, businesses will raise prices to consumers. Consumers’ reduced spending has a direct effect on a business’s top line (revenues) and bottom line (profits). Since cash flow is a direct result of income or profits, it stands to reason that high inflation has a negative effect on cash flow. As a result, it is safe to assume that the company’s value will fall as well.

b) Impact of Inflation on Growth

When evaluating whether to invest or purchase ownership stakes in a business, one of the most essential factors investors consider is the firm’s sustainable growth rate. Due to the prospective nature of valuation, knowing the company’s long-term development prospects is essential for any interested party. High inflation dampens corporate expansion potential since it increases both direct and indirect expenses. As costs are passed through, the customers’ desire for non-essential items drops as a result, slowing economic growth.

For example, long-term leasing agreements with inflation-linked escalation provisions may further increase overhead costs. Inflation may also cause vendors and service providers to raise prices. In a tight labor market, salary increases may help retain competent workers. Rising living costs for low-wage workers might lead to attrition for more costly workers.

The combined effects of the company’s slow growth and low sales hurt its worth.

c) Impact of Inflation on Risk (Discount Rate)

The cost of capital, often known as the discount rate, is the third value driver that may influence the value of a firm. Methods such as the Ibbotson Build-Up technique, the Capital Assets Pricing Method (CAPM), and the Weighted average Cost of Capital (WACC) are examples of some of the approaches that may be used in business valuation when calculating the discount rate that will be applied to a particular firm.

The increase of the risk-free rate, which is the rate that is released every day for the 20-Year Treasury Bond, as well as the rising of the cost of equity and the cost of debt, are where the influence of inflation can be seen to have an effect on the discount rate.

These rates tend to go up whenever inflation does, and as a result, the cost to get funds increases as well. The risk profile of the company is raised and makes it unattractive to investors.

When the discount rate is greater, the value of the firm is negatively impacted, which means that the value of the company is lowered, sometimes by a large amount.

Industries Most Affected by Inflation

Despite the fact that inflation is now pervasive across the economy, not all sectors have been hit equally. Researchers on behalf of Self, calculated the one-year price change from March 2021 to March 2022 in order to identify the industries[3] most affected by inflation.

The table below presents which industries have been the most affected by inflation.

Source: Bureau of Labor Statistics Producer Price Index (PPI)

[3] Moneytalksnews.com: 15 Industries Most Affected by Inflation. Information retrieved on December 6, 2022, from https://bit.ly/3h1e0v9

Conclusion

When there is inflation, a company’s actual earnings fall since a dollar can now only buy a lower quantity of products and services. In other words, a million dollars in “earnings” today will not go as far as a million dollars in “profits” two years ago when it came to buying resources (inflation is a hidden tax).

Profit preservation—and growth—are essential for a company’s long-term viability. In times of high inflation (if possible), cash flow is the primary driver of business valuation, and a company is often sold with the hope that it will continue to earn profits in the future. A company’s value increases in proportion to the amount of cash it can earn and maintain.

Achille Ekeu, MBA, CVA

The Washington Valuation Group

Achille Ekeu, MBA, CVA, is the President and CEO of the Washington Valuation Group, LLC, and a former Board member who served on the Valuation Credentialing Board (VCB) of the National Association of Certified Valuators and Analysts (NACVA). He was also the State Chapter President of NACVA for Maryland and Washington DC. Mr. Ekeu is the Author of a book titled “30 Frequently Asked Questions in Business Valuation”. He focuses on business valuations for tax, transaction, and litigation purposes. He was just recently appointed by Court Order on a big litigation case in Baltimore City, Maryland.

Mr. Ekeu can be contacted at (240)274-9570 or by e-mail at achille.ekeu@washingtonvaluation.com.

Note: This article was first published on QuickRead on December 22, 2022.

Stock BuyBack: Why Do Companies Do It? Does It Increase Business Valuation?

The last 20 years have seen a meteoric rise in the use of share repurchase programs as a means for corporations to raise their profits per share (EPS) outside of improving their core business operations.

But, are buy backs just a gimmick or do they genuinely benefit shareholders?

How Do Companies Buy Their Own Shares, and Why Do They Do It?

After a company has paid for its operating costs, paid the interest on its debt, invested in maintenance spending, and made any growth investments, the free cash flow that is left over can then be distributed to shareholders in the form of ordinary dividends and special dividends. This is something that we have explained in previous articles.

If a firm is unable to locate an investment that is adequate for their needs, rather than spending the money on an acquisition just for the purpose of doing so, they may sometimes use their excess cash to buy back part of their own shares.

After having them repurchased, the company has the option to either maintain them for its employee pension plan or cancel them, therefore lowering the total number of shares that are currently in circulation.

Does It Icrease Business Valuation?

The value of the individual shares that are still outstanding increases as a result of this action, despite the fact that the value of the company as a whole remains same. This is because profits per share rise as the number of shares in circulation falls.

To provide a straightforward illustration, suppose a corporation has 100 million shares of $10 apiece and a market value of $1 billion. If the company spends $100 million in cash to buy back 10% of its shares, the remaining shares are theoretically worth 11.1% more than they were, and the company's value remains the same.

The majority of the time, the announcement that a company is buying back shares will result in an increase in the price of those shares. This is partly due to the fact that the number of shares will be reduced, and partly due to the fact that the market interprets buybacks as a sign that management is optimistic about the future.

The PROS and CONS Of Buybacks

Investors do not have to pay tax on share buybacks, whereas they do have to pay tax on dividend payments; as a result, returning cash to shareholders through a buyback is more tax efficient than distributing cash in the form of dividends. This is one advantage of buying back shares as opposed to distributing cash in the form of dividends.

In a technical sense, buybacks also lower a company's cost of capital. This is because interest gained on cash is subject to taxation, but interest paid on debt may be deducted from taxable income.

As was mentioned earlier, one disadvantage is that any cash that is paid out isn't invested in expanding the business. However, if management is unable to find any opportunities that are desirable for the company, it is preferable for them to buy back their own shares rather than squander the money on a subpar investment.

Conclusion

Although the company's profits per share and return on equity will improve following a buyback because of the decreae in the number of shares (equity) in circulation, the company's true worth will not shift as a result of the transaction.

However, there is a risk that corporations, because of the pressure they are under to consistently reach short-term profitability objectives, would resort to buybacks in order to increase their earnings, rather than investing in the company with the intention of growing it over the long term.

Achille Ekeu, MBA, CVA

The Washington Valuation Group