By: Eamon Moran, Principal of Camlin Advisors
This third installment in the series on entrepreneur- or family-owned companies introduces the reader to the concept of cost of capital and how it influences investment opportunities. In contrast to the first article on preparing for a transaction, and the second article on standards of value, this discussion will delve into some theoretical aspects. By understanding a little more of the economic rationale behind company valuation, the entrepreneur or business owner will be able to better bridge the application of theory to their unique company. In the event a comprehensive valuation of the business is undertaken, stakeholders will better understand how broad economic factors are applied to specific enterprises.
To begin the academic exercise, we start with the premise that the value of an interest in a privately held business is equal to the present value of the future economic benefit. In simpler terms, our stake is equal to the future cash flows of the company valued today. A common claim made by business owners engaged in selling their businesses is to state that the company has generated a certain level of profitability in the past and should continue to do so. While this is an important consideration in evaluating how the business is likely to perform in the future, it is the expected future performance that gives the entity its value. No investor buys a business simply because of how it has performed in the past. Past performance informs, but value reflects the future.
Once we have established that value reflects the future, we have to assess the present value of those future economic benefits. This is accomplished by discounting the forecast cash flows at an appropriate discount rate to establish a fair market present value. The discount rate, also referred to as the cost of capital, reflects the risks associated with receiving the future cash flows, and is expressed as the total rate of return for the given investment. Several means are employed to calculate the cost of capital, but that is beyond our scope in this article. Rather, we will focus on what influences the cost of capital regardless of the method chosen.
Why is the cost of capital so important? As we said just previously, the cost of capital is the expected rate of return for a given investment. Most significantly, it is the rate of return that the market requires to attract investment. As the perceived risk of the investment increases, so too does the return an investor requires. Another way to view cost of capital is as the opportunity cost of foregoing the next best alternative investment. The investment being considered must deliver either higher return at equivalent risk to the alternative, or lower risk at equivalent return to the alternative. It is important for the seller of a business to understand that a buyer (or investor) is not looking at the opportunity in a vacuum. Rather, the rational buyer will not invest if there is a more attractive alternative.
With all this discussion about how risk influences the cost of capital, let’s take a closer look at how risk is identified and quantified. Risk can generally be divided into three principal categories. First is maturity risk. Maturity risk is impacted by the time horizon of the investment. As the horizon increases into the future, so too does the risk of changes in interest rates. A good example of maturity risk can be found in the bond market. Long term bonds experience greater price fluctuation in response to changes in interest rates than do bonds with shorter time to maturity. The second broad category of risk is systematic risk. Systematic risk is the general uncertainty found in the markets as a result of macroeconomic factors. Systematic risk (e.g., the 2009 global financial crisis) is uncontrollable in that it affects all investments across the entire economy. Third, unsystematic risk refers to events and activities characteristic of a particular industry and/or individual business. For example, companies in the automotive industry operate very differently than those in the technology sector. Unsystematic risk, also frequently referred to as diversifiable risk, is based on company-specific factors.
As the owner or operator of a business, understanding diversifiable (or controllable risk) is critical to the ability to influence firm valuation. In no particular order, following are some of the largest contributors to the evaluation of risk by an investor or buyer:
• Asset risk – how is the age and condition of physical assets impacting productivity, maintenance expense and replacement costs?
• Financial risk – is the company successfully managing its capital structure and able to meet its debt and other payments?
• Product risk – is the product mix sufficiently diversified and are new products being developed to replace older ones?
• Operating risk – is the company at risk relative to its supply chain (e.g., supplier concentration) and customer commitments (e.g. investment with the promise of new business)?
• Business risk – is the company sufficiently diversified among its customers to weather sales and growth volatility?
• Regulatory risk – is the company knowledgeable about what risks it faces (e.g. environmental) and is it currently in compliance?
This is but a partial list of unsystematic risks that impact virtually every business. Smaller businesses can encounter additional risks that may be more common the smaller the company. For example, if a company has just a few employees that are responsible for managing and driving the operation, there may exist a high degree of key man risk. If the company were to lose these key employees, what would be the effects on the success of the enterprise?
The natural conclusion to our discussion is that investing in a closely held business regularly involves greater risk, in particular unsystematic risk, than investing in public equities. Higher risk requires a higher return on invested capital. Higher required returns translates into a larger discount rate and therefore a lower value for the smaller, private company. Financial advisors experienced in identifying and managing unsystematic risk can help closely held companies extract greater value when the time comes to realize a transaction or other liquidity event.
Mr. Eamon Moran is Principal of Camlin Advisors and specializes in providing tailored financial services to individual and corporate clients, including Valuations, Transactions Advisory and Strategic Planning. He has more than 15 years of experience in mergers and acquisitions, corporate development, and strategic planning for manufacturing, service and technology firms, among others. Mr. Moran received his BA from Stanford University and his MBA from the University of Michigan. He can be reached at firstname.lastname@example.org