An Analysis of Risk...
I heard Warren Buffet was posed a question a few years back, asking him how he determines whether or not a company is a good entity, worthy of investment. His answer was relatively simple and in fact, sheer brilliant. I will give you his answer later on in this article. Read on…
Most of us can agree that the word “strong” can mean secure, well built, having great resources, well established, rooted, tough, powerful, effective, and a number of other positive attributes. So, let’s assume for argument’s sake, that stronger companies are worth more than weaker companies. After all, if we had an investment choice, wouldn’t we all select to invest in the stronger company if all other parameters were equal? Therefore, the strength of the company is important and the strength should somehow be measured and quantified, yielding a direct relationship to its value. And if we are a buyer or a seller, this is important information.
LET’S START WITH HOW BUSINESS VALUE IS DEFINED
In VERY simple terms, business value can be defined as the ratio of the benefit stream divided by the risk rate:
Using this formula, if you have any two of the variables, the third variable can be quickly calculated.
Example A: Determining Risk Rate. If you loan a friend $10,000 (the value) for one year and ask s/he to pay you back $10,500 at the end of a one year period, then you receive an additional $500 (the benefit). Using the formula above we can determine you are willing to accept a 5% return (the risk rate). ($500/$10,000 = 5%)
Example B: Determining Benefit Stream. If you want to loan your friend $10,000 (the value) for one year and want a 6% return (the risk rate), then you will demand $600 (the benefit). ($10,000 x .06 = $600)
Example C: Determining Business Value. If you are earning $1,000 per year (the benefit) on an investment and your friend is willing to purchase that investment from you but wants a 20% return (the risk rate) on the investment to compensate for risk, then your investment is worth $5,000 (the value). ($1,000/20% = $5,000)
Understanding this math allows us to recognize the relationship the benefit stream and risk rate have to the overall value of a company. So, a higher benefit stream and a lower risk rate results in a greater value.
A benefit stream can be identified in a variety of ways such as; a) pre-tax earnings; b) after-tax earnings; c) net cash flow to invested capital; d) net cash flow to equity; e) earnings before interest & taxes (EBIT); f) earnings before interest, taxes, depreciation & amortization (EBITDA); g) pre-tax excess earnings; h) after-tax excess earnings; or i) projected cash flows. More commonly, in smaller companies, it can be referenced as Seller’s Discretionary Earnings (SDE) which is defined as pre-tax earnings before non-cash expenses plus one owner’s compensation. Although the benefit stream can be considered in many forms, it represents value received on an annual basis.
The benefit stream in a public company can be easily identified because their financials are submitted to the SEC and are available to the public. Thus the word, “public”. In most cases, public companies want to maximize income. Therefore, there are no hidden items on the Income Statement that need to be adjusted (e.g. an owner’s excessive travel or a close relative being on the payroll). A quick glance at the bottom of their Income Statement shows the after tax net income. If you take this after tax net income and divide it by the number of outstanding shares, you will get the income per share (the benefit). Now, if you look at the price per share on the stock exchange (the value), you have two of the three figures above, which allows you to calculate the return rate (the risk rate).
Example: If a public company has an after tax net income of $30,000,000 and there are 60,000,000 outstanding common stock shares, then each share earns $0.50 (the benefit). If the current market price per share is $8.00 (the value) then we can calculate a return of 6.25% (the risk rate). ($0.50/$8.00 = $6.25%)
Since the income figure and stock value are known, we can assume the risk rate is a direct reflection of people’s perception of the risk holding a stake in that company.
For privately held companies, the benefit stream is known, or can be adjusted/normalized for such items as owner’s perquisites, non-operating income or expenses, non-recurring income or expenses, etc. to arrive at the overall benefit stream. Although high growth companies may have a forecasted benefit stream that looks somewhat accelerated, the benefit stream can be determined by calculating the present value of these forecasts. With privately held companies, the business value is undetermined because no one has taken the time to calculate the risk. Only one of the three variables is known. Yes, there are rules of thumb used by certain industries but these are only a guideline and represent the expected risk level for that industry.
A NOTE ABOUT BUSINESS OWNER’S PERSPECTIVE ON VALUE/RISK
I have asked business owners this question hundreds of times: what do you believe your company is worth? I have also polled dozens of brokers that have confirmed my findings. 99% of the time, business owners over-estimate the value of their business. For this to happen over and over, there must be a reason.
In my opinion, if a business owner clearly sees their income (the benefit) and places an over-inflated valuation on their company (the value), then math tells me the owner has under-estimated their company’s risk, imposing an unrealistic, low risk rate compared to what potential investors may see. Why does this occur? I conclude, the current owner does not see the risk, as they have been managing the risk subconsciously and are “too close to the forest to see the trees”. An outside investor, holding their cash, sees the risks clearly, and knows they would be giving up their liquidity in cash to invest in a risk that is for the most part, unknown. Many owners want to impose public company risk rates upon their privately held company. They are in error. Public companies trade at higher P/E ratios (lower risk rates) for many reasons; size, depth of management, etc. One basic reason public companies have a lower risk rate is investor liquidity (the ability of an investor to quickly turn their shares back into cash).
STRONGER COMPANIES HAVE LESS RISK
Do you want to know the strength of your business? Look at the risk or at least the perceived risk. Companies that mitigate risk are companies that are stronger… PERIOD! When calculating risk there are several factors to be considered. Many times a risk rate (discount/capitalization rate) is calculated based upon a build-up method by adding the following:
1) Risk Free Rate: (e.g. U.S. 20-yr Treasury bond rate); plus
2) Equity Risk Premium (rate acceptable to investors to invest in public companies); plus
3) Size Risk Premium (smaller companies have more risk); plus
4) Industry Risk Premium (industries vary in risk); plus
5) Company Specific Risk Premium (detailed below)
The Risk Free Rate, Equity Risk Premium, Size Risk Premium and Industry Risk Premium are all data metrics available through well-established data sources. These figures are widely accepted among the valuation community. The tricky part is the Company Specific Risk component. This risk needs to be monitored at all times and it is the second most important factor to consider in making a company strong, right behind driving sales forward.
COMPANY SPECIFIC RISK
Company Specific Risk can greatly determine the “strength” level of your business and can greatly affect the value as shown by the formula noted earlier. I like to break down this risk into 9 different categories:
1) Operation: Does your business have depth in management? What is the importance of key personnel? Are their few employees where an illness or quick termination may hurt operations?
2) Financial: Do you have stability of earnings or are your earnings sporadic? Are your earning margins equivalent to or above industry averages? Is the overall financial structure sound? Do you have the ability to obtain financing if needed? Do you have a 1-year or 5-year strategic business plan?
3) Market: Is your geographical location inhibiting? Is your business seasonal in nature? Are their large barriers to entry into your industry or can anyone easily assume the role of a competitor? Is the market size large enough for you to expand? Does your market share allow room for growth? Is your sales team experienced and motivated? What is the market strength of your competition? What is the stability of your industry?
4) Economy: What is your dependence on the economy to be successful?
5) Product/Service: Does your revenue mix change often? Do you have a diversity and stability of suppliers? Do you have a diversity within your product lines? What is the relative product/service quality? What is your product/service differentiation to that of other products or services?
6) Customers: Is there diversification among your customer base? Do you have more than 10% of your sales with any one customer? Do you have more than 10% of your Accounts Receivable with any one customer? Is your competition aggressive? Are their growth opportunities within your customer base? Is your pricing competitive?
7) Technology: How does your company stack up in the industry with regard to technology efficiencies?
8) Legal: Do you have pending legal issues? Do you have exclusive contractual agreements? Do you own proprietary content or patents? Are you subject to environmental issues or regulations? Have you asked your employees to sign a “covenant not to compete” contract?
9) Regulatory: Are there any pending regulatory changes in your industry?
These are only some of the risk factors of which your business might be prey. Although many of these factors are subjective, they are actual concerns for a fully informed investor. Any work on your business to reduce these risks and better your risk position will not only increase perceived value, but it will strengthen the overall entity and create more realistic longevity.
I often hear business experts say, “SALES, SALES, SALES!” I do admit that without a strong sales plan, your business is going nowhere, but to make it strong, you must consider reducing risk. Most of the Company Specific Risk components noted above are within your control to change through diversification and planning. Believe me, if you are compiling due diligence documentation for a buyer, you will be asked questions regarding these risk components.
So, how did Warren Buffet answer the question? He said you must look at what the company would look like if you were to raise the price of the product/service by a mere 5%. This is brilliant in that it is both increasing the benefit stream by a factor much greater than 5% (an increase in sales without an increase in cost, dropping a significant net profit increase straight to the bottom line) and it is informing you of the ability of the company to do so, which is in direct relationship to the risk. Don’t we correlate a strong market with having higher prices? If the price can go up with little or no effect on sales or customer blow-back, you have a very STRONG company.
So, ask yourself, “What would your company look like if you were to raise the price of your product/service by 5%?” Most likely your answer will speak volumes on the strength of your business and it will shed light on where you need to reduce risk.
Robert T. Hulet is the President of Business Valuation Solutions, LLC in Pacific Grove, California. He has consulted over 200 companies throughout the U.S. and Canada. Since 2011, he has focused on business valuations and business consulting; also acting as interim management in the positions of COO, CFO, Exec. VP, Board Member & Executive Director on occasion. He has personally started, bought, or sold twelve companies. He is also a private equity investor in multiple companies within the automotive, agriculture, and technology sectors, and is on the Board of Directors of several private companies. He has significant experience in preparing certified business valuations for marital dissolution or shareholder disagreements and for shareholder buyouts, stock sales, and preparing companies for sale. He is a national Financial Planning & Analysis (FP&A) contractor for corporations nationwide. He has completed engagements for corporate restructuring, strategic planning, budget analysis, operations management, business development, cost/benefit analysis, and mergers & acquisition while educating management and negotiating teams. Prior to 2011, Mr. Hulet was the President/CEO of a multi-million-dollar, multi-location U.S. based import/distribution company for over 20 years. He earned four business degrees from the University of Arizona; Accounting, Finance, Management Information Systems, & General Business and has taken additional course work at Cal State University, Fullerton in the area of professional fiduciary management