The Current Economic Environment Requires Business Valuation Professionals to Stay on High Alert

The economy continues to dominate news headlines on a daily basis. The stock markets are extremely volatile, and even the most seasoned economists and financial experts remain at a loss for predicting when things will start to change for the better. As a result, many businesses have had to adjust their projections, lenders continue to place more scrutiny on borrowers, and the consumer is more cautious.

The business valuation community has had to respond to this turbulent environment as well, and analysts have had to pay special attention to the fluctuating market conditions when valuing an ongoing business enterprise. For example, if an analyst has decided to prepare a valuation of a company based on the income approach (one of the three generally accepted valuation approaches), the economic impact must be addressed. After the analyst has completed much of the necessary functions of the typical engagement, including analyzing the financials of the company, normalizing the earnings, assessing the economic and industry conditions, forecasting and evaluating the internal and external risk factors, and estimating the future benefit stream, the analyst must then determine the cost of capital for the company being valued.

Cost of capital is a key factor when determining the value of an ongoing business enterprise. Cost of Capital can be defined as the expected rate of return that the market requires to attract funds to a particular investment. When the valuation analyst determines the cost of equity capital, he or she typically employs what is referred to as a "build-up" method. Basically, the analyst takes the "risk-free rate", or the yield on long term U.S. government bonds plus a risk premium, or rate of return expected for taking on additional risk. In addition, the analyst will consider an industry risk premium, a size premium and company-risk premium for the particular enterprise. The formula is as follows:

Ke = Rf + ERP + IRP1 + SP + SCR

(Where Ke = cost of equity, Rf = risk free rate of return, ERP = expected equity risk premium, or the amount by which investors expect the future return on equity securities to exceed the risk free rate, IRP1 = expected industry risk premium reflecting the relative risk of companies in that industry (if appropriate), SP = size premium, SCR = specific company risk)

As a business valuator applies this formula, he/she typically refers to databases, government publications and other resources to capture relevant data. Needless to say, that data may warrant extra scrutiny in the current environment.
First, due to the extreme volatility in the stock market, money has flowed into treasury bonds causing the yields to drop down to zero and even below at times. If these low yields are used as a proxy for the risk free rate in the build up method, the result will be an unusually low cost of capital. Likewise, as a result of the poor stock market performance, the equity risk premium (which is based on the long-term average of the S&P500) has declined recently. However, the risk associated with holding stocks has clearly not declined.

Third, additional risk premiums, including those for size, might be somewhat unreliable due to recent events. For instance, the theory that a large company is less risky as a result of its size and market share must be questioned now that we have seen so many "too big to fail" companies collapse. Overall, the simple application of the traditional cost of capital calculations will likely result in misleading conclusions due to recent events.

Now more than ever, a thorough business valuation analyst needs to employ his/her judgment when valuing an enterprise. For example, the valuation analyst's experience educational background, insight and peer resources are going to be critical resources. Simply relying on published data points and previously decided case law alone may not be enough. If the valuation analyst chooses to rely only on these traditional methods of analyzes, he/she will likely be subject to skeptical inquiry.

We are in the midst of a very difficult economic environment. Therefore, it is critical that the valuation analyst be alert and well informed about this constantly changing market. In so doing, the valuation analyst's clients will be appropriately served.