The analysis used in a business valuation is no different than the analysis you would do (or should do) if you were to make an investment in a stock. You want to understand how much of a return you can expect from the stock and the level of risk associated with actually receiving that return. Stocks that are high risk, like start-up companies, are expected to have high returns and stocks that are lower risk, like IBM and other ‘blue chip’ stocks, are expected to have modest returns. This relationship is in constant equilibrium; and every appraiser should contemplate expected risk and expected return in the same way.
A business valuation requires the following two activities: a) Projecting business economics and cash flow, and b) Assessing the risk associated with obtaining the company’s projected returns. What follows is a summary of the skills required to perform each activity:
a) Projecting business economics and cash flow.
- Finance/Economics - Analysis of business economics, to include products offered, units sold, price per unit, growth prospects for each, variable expenses, fixed expense, and capital expenditure needs. In short, how does the company make money?
- Finance/Strategy - Benchmarking competitors to understand the status of the industry, the business life cycle of the companies in the industry, and how the company being valued compares to its peers. In short, how much money can we expect the company to make over the next 5 to 10 years and what are investors paying to own similar companies?
b) Assessing the risk associated with obtaining the company’s projected returns
- Finance – Bench marking alternative investments to understand their risk and return profile relative to the risk and return profile of the company being valued. In short, given the returns offered by alternative investments such as stocks, bonds, and US Treasuries, what rate of return would be needed to make the company being valued an equally appealing investment?