Discount rates or multiples when evaluating a company are directly dependent on two variables: the profitability of the business and the associated risk.
Businesses that are more profitable logically command a higher multiple. Similarly, businesses with lower risk are valued at higher multiples than riskier businesses.
This is the reason large companies are sold at much higher multiples compared to small ones. Large companies usually have a long track record, solid management teams, many clients, and so on, in contrast to smaller ones.
So, how is risk assessed by potential buyers when valuing a business? Above all, they want to ascertain the quality and sustainability of the business’ revenues and profits.
Other than the risks concerning general economy and business size, company-specific risks are often present, including the following:
- Customer or supplier concentration: How representative is the contribution of the largest client or suppliers to the business’ profits? What will happen if that particular client or supplier disappears?
- Industry risk: Is the industry in which the business operates growing or contracting? What are the possibilities of a large competitor entering the market? How could new technologies threaten the industry as a whole?
- Regulation or government-related risk: Are there new government rules that could damage the business or perhaps subsidies that could disappear with a change of government?
- Key-man risk: Is the owner or any employee key to the success of the business? What will happen if this person leaves?
- Financial risk: Does the company carry significant debt? Slim gross margins, heavy debt servicing or a combination of both make companies more vulnerable to macroeconomic changes.
Every company has its own specific risk factors, some of which are out of the owners’ control and some that can be mitigated.
Contact Mergex to discuss your business’ particular risks, how they can be attenuated and what impact they could have on your company’s valuation.