Family business directors will make plenty of difficult decisions in 2021, and many of those decisions will require assessing the value of the company’s shares, a particular business segment, or a potential acquisition target. What should you and your fellow directors know about valuation? In our experience, there are six basic valuation principles that can guide directors as they make tough valuation-related decisions in the coming year.
1 – The Principle of Expectations
The view through the windshield matters a lot more than what you can see in the rearview mirror. Of course, it is important to understand historical financial results, but investors pay for what will happen in the future. If you must choose between explaining the past and projecting the future, stick to the future. If profitable investment decisions could be made by studying history, we’d all be rich. The principle of expectations reminds us to remain oriented to the future.
2 – The Principle of Growth
Because business valuation is based on expectations for the future, it stands to reason that growth is a key factor in measuring the value of a business. How will your business grow? To answer this question, it is often helpful to take a step back and situate your family business in the context of expected growth in the overall economy, industry, and local economy. Do you expect to gain or lose market share? What elements of your current (or potential) business strategy support growth expectations? Is there a compelling growth narrative for your family business that would be convincing to potential investors?
3 – The Principle of Risk and Reward
For investments, reward is measured in terms of return. Return follows risk. The principle of risk and reward suggests that an investor considering two possible investments, with one clearly riskier than the other, will require a greater expected return for the riskier investment. Otherwise, there would be no incentive to make the riskier investment.
You can think of risk in terms of the variability in future outcomes. The future returns for an asset are always unknown, but some are more uncertain than others. An asset that will return either +25% or -25% is riskier than one that will return either +10% or -10%. In other words, directors need to think about the future not just in terms of a single base case, but also with reference to the range or dispersion of potential outcomes.
4 – The Present Value Principle
The present value principle describes what is often referred to as the “time value” of money. In short, a dollar to be received at a future date is worth less than a dollar already in-hand. Since valuations are expressed in dollars today, directors need to consider the corrosive effect of time on dollars to be received in the future. The present value principle is closely related to the principle of risk and reward since the riskiness of an investment determines how expected future dollars convert to present value. The greater the risk, the lower the present value of a given amount of future cash flow.
5 – The Principle of Alternative Investments
The supply of potential investments exceeds the resources of any single investor. As a result, every investment is ultimately made to the exclusion of some other investment that could have been made. Economists use the term “opportunity cost” to describe the effect of alternative investments. Valuations are never made in a vacuum but are always assessed relative to the risks associated with, and returns available on, alternative investments in the market. The principle of alternative investments confirms that any valuation conclusion is specific to a particular date. The value of any business changes over time in response to continual changes in the value of alternative investments.
6 – The Principle of Rationality
Financial markets are vast. Even for small family-owned businesses, there are enough market participants to generally keep everyone honest. Yes, you should be on the lookout for that motivated seller or irrational buyer that could provide a windfall for your family business, but you should not blithely assume that such parties will show up when you need them. Competition among buyers and sellers enforces a pretty strict discipline on valuations. There is an underlying rationality to market transactions, even when that rationality may not be immediately obvious.
Conclusion
In our experience, keeping these six principles in view is essential for directors as they deliberate, assess, critique, and develop valuation estimates. For further thoughts on these principles and other elements of valuation, check out our new book, Business Valuation: An Integrated Theory, 3rd Edition, published late last year by John Wiley & Sons.
Our colleagues here at Mercer Capital have completed over 12,000 valuation assignments over the past four decades. If you have a specific valuation challenge that you and your fellow directors would like a second opinion on, give one of our valuation professionals a call to discuss your situation in confidence.
