Valuing Private Companies in a Volatile Economy
During an economic downturn, the business valuation
professional’s understanding of
the subject company and the nuances of its
industry is more important than ever
Valuing a private business in normal times is often
a challenging task, as there is no shortage of external factors that can
influence business value. However, as anyone who follows the stock market on
a daily basis can attest, the concept of “value” is even more difficult to
pinpoint in today’s environment. While this country has been through recessions
before, there are several characteristics of the current recession that make our
jobs as business appraisers particularly difficult now.
We often tell clients that valuing a business is
more art than science. In today’s economy, the artistic portion of the process
has become even more pronounced.
Modeling Future Cash Flows
The value of any investment, including an
investment in a privately held company, is based on the future economic benefits
that are expected to be realized by the investor. What makes the process of
valuing a company today so difficult is that the recent past may not be a
reliable indicator of the company’s future performance. The current recession
has made things difficult not only because many economists consider it to be one
of the deepest since the Great Depression, but also because of the speed in
which it came upon us.
Although the National Bureau of Economic Research
(which officially declares when a recession begins and ends) has retroactively
set December 2007 as the beginning date of this recession, as recently as the
summer of 2008 relatively few economists were willing to state that we were in
the midst of a recession. Just a few months later, the phrases “credit crisis,”
“financial meltdown” and “bailout” were part of everyone’s vocabulary, and there
was no doubt that the economy was in a severe trough. As bleak news worsened
with each passing day, for many businesses it seemed that every individual and
business stopped spending at once.
Now, as we approach the fall of 2009, it is still
unclear whether we are at or near the bottom of the recessionary cycle. And as
valuation professionals set out to value almost any company, estimating profits
in the near term is a difficult chore. The economy leading up to the recent
meltdown is now viewed by many as a “bubble” economy propelled by unrealistic
and unsustainable activities in home lending and buying.
Therefore, as we look at any company’s recent
history of revenues and profits, we have to ask, “What are ‘normal’ levels?”
Results in the latter half of 2008 and the first part of 2009 are probably not
representative, as this economy is considered to be at exceptional depths. But
even if we look at 2004 through 2007, are these results more indicative of
future results given that we now know that the economy was propped up by easy
money? For many companies, especially those involved in construction or with
revenues based on consumer discretionary spending, those years were years of
significant growth. However, for some companies, recent levels of profits may
not return anytime soon. Is going back to 2003 and before (years prior to the
bubble) appropriate to assess expected future results? For many industries, a
lot has changed in the last five or six years. These are the types of questions
that we are dealing with on a regular basis as we value businesses.
Expected Returns on Investment
Projecting cash flows for a business is only part
of the equation when valuing a business. Another variable that must be
quantified is the rate of return that investors require on an investment (e.g.,
the discount rate).
Here, too, the suddenness and depth of the
recession has played havoc. For a private company, business appraisers often
look to both current yields on government bonds and historical rates of return
on stock investments as a starting point for estimating a required rate of
return. However, with the “flight to quality” by investors, yields on government
bonds for most of 2009 are extraordinarily low.
Additionally, the stock market’s nosedive that
began in fall 2008 has possibly skewed historical returns on equity investments,
at least in the short term. In fact, a contingent of appraisers in the valuation
community has been claiming, until recently, that historical returns observed in
the equity markets have overstated the risk associated with equity investments
looking forward. When equity prices declined dramatically, and even during the
rebound that began in early spring 2009, it is unknown whether this claim will
still be made going forward.
What to Do?
So far, this article has raised many questions but
few answers. As with any valuation engagement, the specific facts and
circumstances surrounding a subject company and its industry will largely
dictate how these questions are answered.
What is known is that the current environment
emphasizes even more the need for the business appraiser to work closely with
management and truly understand the subject company. In many cases, the
appraiser may need to work with management to develop cash flow forecasts, since
recent results may be less relevant in providing guidance.
The appraiser may need to look closely at the
industry and understand how deeply it is being impacted by the current economy.
Industry-specific metrics that are followed and predicted by a stable of
investment analysts may need to be looked at more closely by the appraiser.
Examples of these metrics might include the number of housing permits issued in
the local area, the number of units or volume sold in the industry, occupancy
rates, or the number of subscribers. The appraiser may even consider using
regression analysis to correlate historical revenues of the subject company to
these industry metrics, and using this analysis – along with the most recent
industry forecasts – as a basis for assisting management with its projections.
Uncertainty is the pervading theme in the world of
finance today. The IRS recently issued guidance to its Small
Business/Self-Employed Division with respect to the current uncertainties
regarding real property appraisals and evaluating offers by taxpayers for
compromise. The memo states in part:
“All [IRS] employees should be
sensitive to the current economic conditions that may be affecting taxpayers
when investigating the acceptability of an offer. Employees should continue to
utilize all available resources to arrive at the most accurate property
valuation possible, including a discussion with the taxpayer or their
representative, or both, on the methods used to value the taxpayer’s property.”
This guidance wasn’t directly aimed at business
valuation, but the IRS acknowledges the difficulties created by current economic
conditions in determining value.
(Note: While those difficulties complicate
the work of business appraisers and cloud the decisions of business owners, they
offer a silver lining for some business owners and high net worth individuals.
Dramatic declines in the values of real estate, marketable securities and
closely held companies offer unique opportunities to reduce one’s taxable estate
by gifting assets that are temporarily – we all hope – depressed in value.)
Practicality and logic
In the end, whatever
approaches or methodologies are utilized, practicality and logic must still
While business valuation will always be more art
than science, the current environment of uncertainty is not an excuse for the
business appraiser to abandon all common sense just so that he or she can paint
the picture the client desires. ■
The opinions expressed in this article
are those of
the author and do not necessarily reflect the views and opinions of Kotzin Valuation Partners.