Informеd Dеcision-Making:

Businеss valuation is a vital tool in making wеll-informеd dеcisions.  For businеssеs еarning $20 million or morе in rеvеnuе,  stratеgic dеcisions rеgarding mеrgеrs,  acquisitions,  divеstiturеs,  or intеrnal rеstructuring can havе significant impacts.  With a prеcisе undеrstanding of businеss valuе,  еxеcutivеs,  sharеholdеrs,  and stakеholdеrs can wеigh thе potеntial risks and bеnеfits of diffеrеnt stratеgic options,  еnsuring thеy align with long-tеrm businеss goals. 

Accuratе Financial Rеporting:

Accuratе financial rеporting is crucial,  еspеcially for largеr businеssеs.  A profеssional businеss valuation providеs a fair and objеctivе assеssmеnt of a company’s financial hеalth and ovеrall valuе.  This assеssmеnt еnhancеs transparеncy and crеdibility whеn prеsеnting financial statеmеnts to invеstors,  rеgulators,  and lеndеrs,  building trust and strеngthеning thе company’s rеputation within thе financial community. 

Mеrgеrs and Acquisitions (M&A):

Businеssеs еarning $20 million or morе in rеvеnuе arе attractivе targеts for potеntial buyеrs or partnеrs in mеrgеrs and acquisitions.  A prеcisе businеss valuation еnablеs sеllеrs to еstablish a fair asking pricе basеd on concrеtе financial data,  еnsuring nеgotiations arе basеd on facts rathеr than spеculation.  Buyеrs can assеss whеthеr thе acquisition aligns with thеir stratеgic objеctivеs and if thе proposеd pricе is rеasonablе. 

Capital Allocation and Invеstmеnt Dеcisions:

Efficiеnt capital allocation and invеstmеnt dеcisions arе crucial for growth and еxpansion.  Businеss valuation providеs insights into which aspеcts of a businеss gеnеratе thе most valuе,  guiding rеsourcе allocation for optimal rеturns.  For largеr businеssеs,  this is еspеcially important as misallocatеd funds can lеad to missеd opportunitiеs and wastеd rеsourcеs. 

Compliancе and Rеgulatory Rеquirеmеnts:

Largеr businеssеs oftеn facе complеx rеgulatory framеworks and rеporting standards.  Accuratе businеss valuation hеlps mееt thеsе rеquirеmеnts by providing a wеll-documеntеd and dеfеnsiblе valuation figurе.  This rеducеs thе risk of rеgulatory finеs,  lеgal disputеs,  and еnsurеs compliancе with thе law. 

Estatе Planning and Succеssion:

Effеctivе еstatе planning and succеssion stratеgiеs arе vital for businеssеs еarning $20 million or morе in rеvеnuе.  Prеcisе valuation hеlps dеtеrminе thе fair valuе of thе businеss,  facilitating informеd dеcisions rеgarding inhеritancе,  taxеs,  and assеt transfеr.  This protеcts thе company’s lеgacy and prеvеnts potеntial conflicts among hеirs. 

Conclusion:

Undеrstanding thе actual valuе of a businеss is crucial for succеss,  and for businеssеs еarning $20 million or morе in rеvеnuе,  a profеssional businеss valuation is vital.  Such sеrvicеs providе objеctivе and accuratе insights that influеncе dеcision-making,  еnhancе financial rеporting,  support mеrgеrs and acquisitions,  and еnsurе rеgulatory compliancе.  From capital allocation to succеssion planning,  thе advantagеs arе numеrous.  Apprеciating thе valuе of businеss valuation allows largе businеssеs to crеatе a path for sustainablе growth and to achiеvе еnduring succеss in a continually changing markеt. 

The post Thе Importancе of High Quality Businеss Valuation for Businеssеs Earning $20 Million or Morе in Rеvеnuе appeared first on Intelek Business Valuations Australia.

The Fed’s countermeasure for the historically high inflationary environment has resulted in continual increases of interest rates since March 17, 2022, with its latest rate hike being on March 2, 2023. The total increase of the Fed’s fund rate from Feb 2022 to Feb 2023 has been 449 bp, sitting, from 4.75% to 5.00%, and taking the Fed’s Funds Rate back to pre-2008 financial crisis levels.

Note: Board of Governors of the Federal Reserve System (US), Federal Funds Effective Rate [FEDFUNDS], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/FEDFUNDS, April 4, 2023.

How Interest Rate Hikes Impact Businesses

Interest rates hikes have direct and indirect impacts on the operations of a business including, but not limited to:

Consumer Demand for Goods and Services Lowers

On a consumer basis, demand for goods and services is negatively impacted. Interest rate hikes may decrease consumption as credit card rates are higher, opportunity costs of consumption in the present also increase as savings rates are more attractive. Another impact on consumer demand for goods and services is the reduction of disposable income due to the periodic increase in monthly mortgage expenses on adjustable-rate mortgages.

Higher Cost to Service Debt

As interest rates rise, the businesses’ interest expense to service debt increases. Some businesses might be running on limited margins or situations where the rise in interest expense can cripple the company. As a result, a business will rethink taking on any new debt or might look for cuts in expenses. If businesses are fortunate enough to have strong demand, they may be able to pass some or all of this on to the consumers.

Slower Growth

Due to higher costs to access loans, businesses will attain slower growth. Funding is key for many businesses to cover working capital or capital expenditure requirements when looking to grow or expand their operations. As a result of higher costs to service debt and uncertainty due to high inflation and interest rates, businesses choose to step back on growth or expansion opportunities.

Lower Investment and Businesses Demand for Goods and Services

As a result of lower consumer demand, businesses stepping back due to higher costs of debt and economic uncertainty, businesses’ demand for capital goods can decline as their income declines, and they choose to be conservative out of fear of a potential recession.

Rise of Unemployment

Considering all the impacts herein mentioned such as lower consumer disposable income, higher cost to service loans, and restricted investments under a period of uncertainty, companies might take the decision to lay off workers.

In summary, the potential consequences of high interest rates for a business are numerous and vary degrading for a country’s economy. However, not all businesses are affected in the same way, and for some, the consequences above are a combination of several factors which may not impact certain industries or companies that heavily; e.g., companies with a good stream of cash flows, sectors with low requirement for debt or with less sensitivity to the economic conditions based on the type of goods or services provided.

How High Interest Rates Impact Business Valuations

Nevertheless, even if a business is not materially impacted by any of these factors and can continue its operations as usual under a high inflationary environment and several interest rate hikes, its valuation can be affected because of the required rate of return or discount rate from investors. This is due to different components in the building of a discount rate or required rate of return such as:

• Risk Free Rate
• Cost of Debt
• Equity Risk Premium

The risk free rate is the rate of return that an investor can receive from investing in a “risk-free” asset. As the required rate of return is built based on a trade-off between risk and returns, if I can get a higher return from a “riskless” asset, would I require the same returns from a riskier one? Generally, a higher return would be required from the riskier asset. A risk-free investment is often considered a treasury (government) bond, of 20 years.

Cost of debt is the effective rate paid for loans or bonds by a business. As the interest rate increases, the cost of debt of a company increases as well.

The equity risk premium (“ERP”) is the additional return from the risk-free rate that investors expect as compensation for investing in a well-diversified portfolio of stocks. E.g., how much more you would expect to earn from investing in a stock index such as the S&P 500 (riskier asset) than the risk-free assets.

The preferred reference used by analysts for the risk-free rate is the spot 20–year Treasury bonds yield rate. Here are the increases in the risk-free rate from December 2021 to February 2023:

In the case of the cost of debt, it can be determined based on yields from corporate bond indexes (whether investment grade or non-investment grade) or on the Company’s historical average effective interest rate on its loans, among other methods. For example, if we take the ICE BofA Corporate Bond Yield graded BB, the cost of debt went from 3.40% in December 2021 to 7.14% in December 2022.

The Equity Risk Premium (“ERP”) is a forward-looking concept. However, it is an expectation as of the valuation date. Different methods to calculate it include normalized ERP measures from well-known agencies, long-term historical realized ERP, among others. In practice, analysts may not change their ERP based on recent risk-free rates variations but do consider other factors in the calculation of ERP.

Now, how does all this impact the company’s value? Does a 3% move in the risk-free rate mean a 3% discount (reduction) to the value of your business? Let’s first see a simplified example of how increases in the discount rate can impact a business’ value.

Example 1: How much do increases in discount rate impact a business value.

Let’s say we have a small restaurant which is expected to generate $100k in cash flows (referred to as CF) as of the valuation date and these cash flows are expected to grow into perpetuity at a rate of 3% (referred to as g). Let’s explore 3 scenarios, (1) with a 15% discount rate (referred to as k), (2) a 17.22% discount rate (the same as the increase in the risk-free rate from December 2021 to December 2022), and (3) a 20% discount rate.

Using the capitalized economic income method, we will find the enterprise value with the following formula:

The results are as follows:

As shown above, a 2.2% increase in the discount rate, yields a decline in value of 15.5%, and a 5% increase in the discount rate yields a decline of approximately 30%.

It is important to note that, while the risk-free rate has increased 2.2% from December 2021 to December 2022, it does not mean that the discount rate (or weighted average cost of capital “WACC”) calculated for businesses increased 2.2%. The building of a discount rate has many different components which are constantly affected by everyday market factors aside from interest rate hikes. The most used formula to calculate WACC is:

Where:

Ke= Cost of equity

We= Equity as a % of capital structure

Kd= Cost of debt

Wd= Debt as a % of capital structure

t= Corporate statutory tax rate

As explained, the cost of debt will increase as the Fed’s funds rates increase, and as a result, it will increase the WACC. Risk-free rate is a component of the cost of equity. Analysts will generally use the Capital Asset Pricing Model (“CAPM”) to compute the cost of equity, which formula is as follows:

Where:

Rf= Risk free rate.

ERP= Equity risk premium.

Ri= Industry risk premium, measured by calculating the historical relationships between the return of the industry to which the individual asset belongs to and the return of a broad market index such as the S&P’s 500.

CSRP = Company specific risk premium, is a measure of risk which is specific to the company. The factors considered by analysts include size, liquidity, solvency, among other qualitative and quantitative factors.

Per the above formula, as the risk-free rate increases the Cost of Equity also increases; nevertheless, it is not on a directly proportional amount because Industry risk premium, ERP, and a company’s CSRP may vary as well.

To provide you with a real life but simple example, we have calculated the discount rate for the same restaurant with $100k in cash flows considering actual market data as of December 31 2021, and December 31 2022. In addition, we also considered a business (1) which has 20% debt in its capital structure and a business (2) that runs without any debt. The results were as follows:

Example 2:

There are a few things that we can point out from this simple exercise:

(1) a 2.2% increase in the risk-free rate did not equal to a 2.2% increase in the business’ discount rate (while the increase to the cost of equity can be 2.2% in some cases, it would not be a direct consequence of a higher risk-free rate).

(2) business 1, which has debt, exhibited a higher increase in its discount rate (1.20% vs 0.80%), this is as a result of the 20% debt in its capital structure (being leveraged).

(3) Consequently, the decrease in value of business 1 was higher than the decrease in value of business 2.

(4) We can see that whether a business is leveraged or not, in the restaurant industry the risk-free rate has affected its value prior to accounting for any potential changes being experienced in its financial performance and capacity to generate cash flows.

(5) The leveraged business has a higher value than the non-leveraged business, however, this is not always the case. Several other factors that fall outside the scope of this article will come into play.

Please note that this is an overly simplified example to show the impacts of inflation to the discount rate, however, the calculation of discount rates is affected by several factors such as the stage of the business, size, expected future performance, solvency, liquidity, profitability, and several other factors which are recommended to be undertaken by a valuation expert. Furthermore, the impact of interest rate hikes on the discount rates can vary depending on the industry being analyzed as well.

Finally, consider that in the case of privately held businesses this is not the final step to finding a business’ value, as the final result will depend on several factors.

Our thoughts….

One of the main objectives of a central bank is to keep tabs on inflation and make sure that target inflation is achieved. The main instrument the Fed has to control inflation is changing interest rates; nevertheless, a high inflationary environment with high interest rates puts a toll on the economy and businesses as explained in this article. If you’re planning to sell your business, or change its entity structure for estate planning, or look at gifting equity, it’s important to understand how the macroeconomic environment affects its value and speak with your advisors for when the most opportune moment to take action is.

If you would like to understand more, please visit our articles on a successful business valuation engagement, business valuation methods, or how discounts are calculated in business valuation for estate planning purposes and their advantages for tax purposes.  

The post How Higher Interest Rates Have Impacted Your Business’ Value appeared first on Intelek Business Valuations Australia.

Here we will explain 10 items that your business valuation report should include:

1. Business valuation expert

First and most important is that the appraiser preparing your report should be an expert with relevant education, experience, and/or membership to professional appraisal associations via their certification. By following these criteria, the accredited appraiser should provide a level of quality that reduces your risk of adverse outcomes. This is because they have to follow a particular framework and industry standards, giving a baseline of quality required for such a service. In saying this, the accreditation alone does not mean that high quality is guaranteed, so do your homework. See our guide here on how to successfully navigate the selection process of your appraiser.

2. Valuation Date

The valuation date of a business appraisal is crucial as any conclusion of value is only to a specific point in time. The value of an asset does not stay the same regardless of time, in fact, it can change significantly from one day to the next, by way of closing a new client that increases profits by 20%. For estate planning, the date of gifting or date of death are the most common valuation dates.

3. Purpose of the Valuation

The purpose of an appraisal will define the type of ‘standard of value’ (step #11) to derive. A standard of value will change the perspective through which your business is valued. In the case of estate planning the IRS requires that the standard of value is fair market value which they define as:

“[T]he price at which property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of the relevant facts.”

For this reason, as estate planning is done under a hypothetical transaction, where the amount of tax to be paid should be fair, the fair market standard is required, and not investment, strategic, synergistic value will suffice.

4. Outline of the Valuation Process

The description of the appraisal process is key because it will inform the reader of assumptions considered, any hypothetical conditions, and any limiting conditions and restrictions that affected the analyses, opinions, and conclusions of the business appraisal presented. Business valuation is as much art as it is science, which is affected by many assumptions and conditions, for this reason each must be included in the report to assure proper process and assessment when scrutinized.

5. Information Considered

All data and information used in determining the value of a business should be included with enough detail in order for any person that reads the report to be able to replicate the process and arrive at the same conclusion.

6. Valuation Approach(s)

There are different valuation approaches that can be applied in a business valuation, all three approaches, Income, Market, and Asset approach, must all be considered with one or more correctly applied, depending on which are determined appropriate. The explanation should include the reasoning behind the selection process of the approach(es), application and conclusions.

7. Valuation Method(s) Applied

Each valuation approach has one or more valuation methodologies, and all valuation reports should express in detailed the different methods applied. Including an explanation of the selection of each method and the procedures followed in their application. For example, in the income approach, an appraiser may choose the discount cash flows method or capitalization of earnings method. Although both methods are within the income approach, they are fundamentally different and depending on the individual case facts, one is more applicable than the other. These decisions should be explained in detail in the valuation report.

8. External Information Relied Upon

Any specific external sources of data relied upon must be included in the valuation report, with specific detail as to their use and application. For example, comparable information such as comparable transactions, (the sale of similar businesses / interests), the use of empirical studies for identifying the cost of capital and relevant discounts, and so on, must be included in the report. This is so the reviewer of the report (the IRS) can verify the source of the inputs used and reconstruct the value.

9. Factors of Analysis Required

Per the IRS revenue rulings, there are 8 factors which require careful analysis in a business valuation:

1. Nature and history of the business
2. Economic and industry analyses
3. Book value of the stock and financial condition of the business
4. Earning capacity
5. Dividend paying capacity
6. Goodwill or other intangibles identification if applicable
7. Sales of the stock and size of the stock to be valued
8. Market price of publicly traded stock in the same or similar line of business

These 8 factors should always be considered but this doesn’t mean that they are always relevant for all businesses. Furthermore, depending on the case, a business may require many other factors to be carefully analyzed.

10. Reasoning Behind Valuation Discounts

Valuation discounts can be one of the most essential parts of a business valuation when applicable as discounts applied for the valuation of closely-held businesses can reach up to 70% of its equity value under certain circumstances. There are several potential discounts applicable, see this article that explains them in more detail. Given the impact that these have on a business’ value, this is one of the most heavily scrutinized parts of the valuation and hence, requires a careful and detailed explanation in the report.

In conclusion, following a specific report structure for estate planning purposes is critical to developing a conclusion of value that is defensible, helping to avoid challenges from the IRS that can result in audits, investigations, penalties, fees, and or litigation. Ensure that when undertaking your business valuation your selected appraiser has adequately covered these 10 items.

The post 10 Things Your Business Valuation Report Must Include for Estate Planning appeared first on Intelek Business Valuations Australia.

First, there are 3 different valuation approaches to value a business, the income, market, and asset approach. Within these, the most commonly applied methods are:

• Income approach: based on a future income stream brought to the present value. Methods applied are:
  • Discount Economic Income Method
  • Capitalized Economic Income Method
• Market approach: based on comparable transactional data available of public or private businesses as guidance to determine the business’ value. Methods Applied are:
  • Guideline Public Company Method
  • Guideline Transaction Method
• Asset approach: based on determining a balance sheet of the business adjusted to fair market value. Methods applied are:
  • Asset Accumulation Method

How are these business valuation methods applied?

Income Approach – Discount Economic Income Method: Commonly known as the DCF method, usually this method is applied when the company has a volatile historical financial performance or there is a reasonable expectation for significant increases or decreases in financial performance to occur in the foreseeable future. This method uses three main variables,

1. projected economic income within a forecasted period of, usually, 5 to 10 years. Appraisers will generally use net cash flows to invested capital which refers to the amount of cash flow generated prior to consideration of how a company is financed,
2. projected economic income that is into perpetuity, in line with the company’s historical financial performance, position, and management expectations, and
3. a discount rate to bring all projected economic income to the present value. (present value meaning today’s value of future earnings, a dollar today is worth more than a dollar in a year’s time).

The discount rate is a measurement of the risk associated to the future earnings. It’s affected by several different factors such as the company’s historical financial performance and position, macroeconomic and industry landscape, size of the company, and specific factors isolated to the company that are not captured elsewhere, among others. The rate represents the required rate of return that an investor would require of the business for the risks associated with it. All investments carry risk, and a privately held business is no different, in fact is often considered a risker investment, compared to treasury bonds, or the stock market.

Example of DCF application 

Let’s say that an HVAC company’s revenue is $1 million and are expected to grow annually at a 15% rate for the following 5 years. Afterwards the company reaches a mature stage and starts growing at a rate of 3%, in line with the target inflation of the economy, into perpetuity. Finally, the company’s net cash flows to invested capital (referred to as earnings in this example) will be 10% of revenues (for simplicity, this will include into perpetuity, however often this percentage does not hold with changes to revenue growth and other considerations) and the required rate of return or discount rate applicable will be 20%.

First of the two stages: Forecast Period

First, in order to bring the projected earnings to the present value we apply the following simple formula:

The period refers to number of years into the future that the earnings will happen in. The earnings in the next 5 years will look like this:

We then apply our present value formula to each of the future earnings and the sum all present values. This will result in the following:

Second of the two stages: Terminal Period

Finally, we need to find the present value of the stream of earnings that will continue to occur into perpetuity (usually called the Terminal Period). For this we use the constant annual growth rate of 3% (let’s call it ). For this we find the terminal period value of the stream of earnings into perpetuity first, (before discounting it to the present value), so we apply the following simple formula:

Keep in mind that means the earnings in year 5. The calculation looks like this:

This resulting value will always be as of the last period of the forecasted period, hence period 5 in this example. (The reasoning for this is beyond the scope of this article); It then needs to be discounted to the present value using the present value of earnings formula. To complete the calculation,  you must sum together the present value of the forecast period and the present value of the terminal period, shown below. This will yield the value of the Company’s business (commonly referred to as enterprise value).

Income Approach – Capitalized Economic Income Method

Usually, this method is applied with stable and mature businesses where there are reasonable expectations that no significant changes to the company’s financial performance or associated risk level will happen in the foreseeable future. This method follows the same logic of the prior one, but the earnings measures are expected to grow at constant rate into perpetuity; meaning there is no initial period of volatile change. This stream of earnings is brought to the present value using a capitalization rate which is calculated as the discount rate (same as the one in the DCF method) minus the constant growth rate at which the earnings are expected to grow consistently into the future.

Example of Capitalized Economic Income Method application 

To keep it simple, we will continue with the previous example and keep the same revenue of $1 million and 10% earnings as a percentage of revenues. There won’t be any high growth in the following 5 years, only a constant growth into perpetuity of 3% (also referred as  in this example) and the same discount rate of 20%. The formula most commonly applied is:

As you can see the formula is very similar to the terminal period from the DCF example. This would then result in the following:

This method is much simpler than the DCF method as you can see. Again, you should be able to easily replicate the results following the formula.

Market Approach – Guideline Public Company Method

This method leverages the vast amount of publicly available data of public companies to find suitable comparables to the company being valued. The basis for comparability depends on the industry where the company operates, operational similarities, size, profitability, or any other criteria depending on specific case facts.

Once comparable companies are found, the appraiser uses valuation multiples of different measures, generally being price-to-revenue, or price-to-EBITDA (earnings before interest, taxes, depreciation & amortization), among others, creating a range of valuation multiples. Finally, a valuation multiple is selected from this range based on the company’s historical financial performance and other qualitative specific analyses relative to the case facts and the selected public comparable companies.

Guideline Public Company Method Example 

Let’s continue with our same HVAC company making $1 million, but we will now use EBITDA equal to 10% of revenues (or 10% EBITDA margin). Now, let’s assume that we found similar companies with significantly larger revenues, with the following EBITDA margins and the price-to-EBITDA (or EBITDA multiples) looking like this:

We can see here that the public comparables EBITDA multiple (price-to-EBITDA) grows as profitability increases (this does not always happen but we want to keep things simple). Now, reviewing that our company has a 10% EBITDA margin and its revenues are much more smaller than the public comparables’, all else equal, we can choose a 4x multiple. Again, the analysis will usually be more complex, but we will assume the 4x is applicable for simplicity.

Now all we have to do is multiply our company’s EBITDA by the valuation multiple selected. The result will be:

Market Approach – Guideline Transaction Method

Different to the guideline public company method, this method uses transactional data from privately held comparable companies. Such data is harder to find but there are some databases with sufficient information to search comparable companies. The basis of comparability is the same as with the prior method, based on the range of multiples derived from the comparable private companies, one multiple is selected and applied based on the same criteria as with the prior method.

Guideline Transaction Method Example 

Let’s use our guideline public company method’s example but instead of public companies, we have private companies with similar revenues to the company we are valuing. The variables of the private companies will be the following then:

As we can see profitability margin is the same but they trade at lower multiples, often because the market associates higher risk due to the smaller size of the companies and lower quality information that accompanies privately held companies, (however, this is not always the case). All else equal, considering our company has a 10% profitability margin, we chose a 4x multiple. The final valuation will look like this:

It’s important to keep in mind that these methods from the market approach are considered more relevant as the number of comparable companies found grows (meaning more data points makes it more reliable). However, if a small set of highly comparable companies is found, the results of the application of the methods can be as relevant as the results from the bigger set of comparable companies.

Asset Approach – Asset Accumulation Method

It’s more commonly applied when a business will be liquidated, but there are cases when it’s applicable for businesses expected to operate into perpetuity. In the Asset Accumulation Method, the appraiser will restate all the assets and liabilities of the company being valued to an appropriate standard of value (let’s assume fair market value). After the revaluation of all assets and liability accounts, the analyst can then apply the assets minus liabilities formula to indicate the value of the total equity.

The reason why we need to restate the values to fair market value is because values as shown in the balance sheet are accounting values and may not be reflective of their fair market value. The process of going through each value is very exhaustive and can be extremely difficult to do so for certain types of assets, and may need specialist appraisers for specific assets (like machinery and equipment appraisers, or real estate appraisers) to properly apply the method.

Asset Accumulation Method example 

Continuing with the HVAC company, let’s assume it has the following assets and liabilities and their respective fair market values will be as shown:

Shown like this, the method looks simple, but it can become extremely complicated and there may also be assets not recorded on the balance sheet that could be missed. Examples can be brand recognition, intellectual property such as patent and copyrights, among others. These are called Intangible Assets, and they can be hard to identify and value, requiring the skills of a specialist intangibles appraiser.

Our Thoughts…

When valuing a business, all valuation approaches must be considered and one or more can be applied, depending on the case facts and available information. On the surface the methodologies may seem simple enough; however, this article only scratches the surface to the depths of knowledge required for their correct application, where a very experienced and competent appraiser is worth their weight in gold. All valuation purposes benefit from an experienced and competent appraiser, but the riskier the situation (money on the line) the more competent appraiser you will want to hire.

Furthermore, for privately held business valuations, there is one key concept being discounts, which is often applied and that we have not touched on. See our article here that explains discounts for privately-held businesses, which can subtract up to 70% of a business value (very convenient for tax purposes).

If you would like to know more, speak to one of our accredited appraisers.

The post Business Valuation Methods – How to Value a Privately-Held Business  appeared first on Intelek Business Valuations Australia.

First, it’s important to understand the standard of value on which your privately held business is valued. Under the standard of valuation for gift and estate tax purposes most used by the IRS is ‘fair market value’, where the business valuation expert will find the value at which a business would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts, as defined by the IRS. The standard of value is an important part of the valuation framework because it impacts what discounts are applicable.

Business Valuation Discounts

The most common valuation discounts applicable to privately-held businesses are for lack of marketability (“DLOM”), lack of control (“DLOC”), key man risk, and discount for lack of liquidity (‘DLOL”). These discounts can add up to 70% of a business’ equity value, depending on several factors. The reasoning behind each discount is as follows:

• Discount for Lack of marketability – refers to a discount applicable to assets that don’t have a readily available market to be sold on. For example, a 10% minority interest in a privately-held business has a very limited amount of marketplaces where it can be sold, for this reason, investors will apply a discount as all else equal, as the buyer is compensated for the cost of lack of marketability.
• Discount for Lack of control – A non-controlling interest is considered to be less valuable than a controlling interest in a company, since control prerogatives, like compensation determinations, policy setting, deciding to sell or liquidate, and declaring dividends, can impact a business value. Thus, when non-controlling or minority interests are valued for a privately-held company, a discount for lack of control is often applied.
• Discount for Key Man Risk – For some privately-held businesses, a discount for key man risk might be applicable when the cash flows generated by the company are closely tied to a key person. For example, the ability to generate revenue, or operational know-how being tied to one key person. Thus, if the key man was to become incapacitated, pass away, or simple quit, the same cash flows would be at a higher risk of not being generated, and hence a discount is applied.
• Discount for Lack of Liquidity – Liquidity refers to the ability of converting an asset into ready cash without affecting its market price. Liquidity has a close relationship to marketability; generally, a non-marketable asset will be illiquid, but not the other way around. An example is a 10% non-controlling interest in a private business which can be non-marketable vs a 100% controlling interest in a private business which is marketable through different avenues such as sale by an investment bank, or business broker, but it will still take on average of 6 – 9 months to be sold vs the 3 days that a stock of a public company takes to be sold.
• Discount for Built-in Gain Taxes – Some privately-held businesses have assets that would be subject to capital gains tax if sold, which can be taken into account when valuing the business for estate tax purposes. For example, John owns a privately-held business that specializes in the manufacturing of widgets. The business has been profitable for many years and has accumulated a significant amount of inventory. The inventory is valued at $500,000, but if it were sold, it would generate a capital gain of $200,000. Thus, in order to avoid double taxation, built-in gain taxes reduce the value of the business.

How to Determine / calculate a Privately Held Business Discount

Business owners will need a qualified business appraiser to determine appropriate discount(s) based on an analysis of the company being valued and specific case factors such as, the size of the interest, or restrictions outlined in the articles of incorporation / shareholder agreement, among others. This is a very sensitive process as erroneously determining a discount might lead challenges from the IRS, including audits, fees, hefty penalties, and litigation fees, in addition to the appropriate estate tax liability determined by the courts.

Adequate disclosure of gifts for gift tax purposes and non-gift completed transfers to family members often require a qualified appraisals, as defined by Treas. Reg. § 301.6501(c)-1(f)(3). These include that the valuation expert is qualified to appraise the gifted asset under relevant qualifications such as education, experience, and/or membership to professional appraisal associations. Courts usually take note of accreditations, professional affiliations, and credentials, such as the CFA, ABV, ASA, CVA, and CBA. Click here to see an article on how to select the right accredited appraiser.

Valuation appraisers will use different tools to determine the discounts applicable to privately-held business interests such as:

• Discount for Lack of Marketability: Two types of empirical studies are commonly used to determine discounts for lack of marketability which are restricted stock studies and pre-initial public offering (pre-IPO) studies. Approximately 15 restricted stock studies exist which analyzed the differences in value of restricted stock to their respective publicly traded stock, restrictions that were imposed by the SEC. Pre-IPO studies compare the price at which a stock was sold while it was still privately-held with the price of the same company’s common stock after its IPO (now a public company).
• Discount for Lack of Control: The discount for lack of control is usually quantified by comparing the trading price of shares of publicly traded, closed-end investment funds to the net asset value per share of the same funds. For companies holding real estate, the discount is determined by comparing the trading price of shares of a selected sample of registered real estate limited partnerships (RELPs) or real estate investment trusts (REITs) to the net asset value of the respective shares.
• Key Man Discount: Although there is no empirical methodology for establishing key man discounts, the discount should consider services rendered by the key person and degree of dependence on that person, likelihood of loss of the key person (if still active), health and age of the key person, risk of person to compete (without a noncompete agreement), depth and quality of other company management, amongst others, and the impact on cash flows if any of these impacts were to happen.
• Discount for Built-in Gain Taxes: The discount for built-in gain taxes is determined based on the applicable capital gain taxes that would be generated from selling different assets held by a company.

Current Tax Law and Valuation Discounts

Under the current tax law, people can give $12.92 million in 2023 per person in gifts over the course of their life without incurring gift taxes. There are set amounts per year whilst living, and then the remainder after death. However, this provision is set to expire at the end of 2025.

The Build Back Better Act (H.R. 5376) was introduced in the House of Representatives on September 27, 2021. If this bill is signed into law, non-operational assets will not be applicable for discounts. For more context, currently, when valuing a business, discounts are applicable to the 100% equity held by a business, even real estate, related party loans, and/or investments in assets not related to the operation of a business. If the bill passes, these assets will not be applicable for discounts.

Conclusion

Valuation discounts have a significant impact on estate tax liabilities as the privately-held businesses value can be discounted by up to 70%, depending on several factors. Nevertheless, the application of discounts should be determined by an expert business appraiser to avoid potential IRS challenges, audits, penalties, and worse, litigation.

The post How Discounts can Lower the Taxable Value of Your Business for Estate Planning appeared first on Intelek Business Valuations Australia.

Liquidity and marketability are often used interchangeably by many business valuation appraisers; however, there is a significant difference often missed, leading to improper determination of the discount applicable to a business value. This can lead to higher risk of improper taxation, over payment for equity interest purchases, or higher risk of audit and investigation if under an employee stock option plan (ESOP).

Though both terms have a close relation they are not the same. Liquidity is defined as the capacity of an asset to be converted into ready cash without affecting its market price, while marketability is a term used for assets which have a readily available market. Generally, a non-marketable asset is also illiquid, but an illiquid asset is not necessarily non-marketable.

Tricky right? They both sound very similar. In the case of private businesses, a 100% controlling interest in a closely held business is in fact marketable as there are different avenues through which they can be sold, such as investment banks, business brokers or internet-based markets. This means there is a readily available market where sellers and buyers can meet and trade such assets.

Are Discounts Applicable to a 100% Controlling Equity Value of a Company?

A privately held business, although marketable it’s still not liquid. According to some brokers, a small business can take on average between 6 and 9 months to sell. This illiquidity vs the 3 days liquidity in the stock market, conveys a loss in perceive value of the private business.

For this reason, although a 100% controlling interest is marketable and requires no discount for lack of marketability, investors will punish it or apply a discount for lack of liquidity.

Not making the accurate distinction between marketability and liquidity, and their appropriate application in the valuation process, can lead to an improper taxation for a business owner. If 100% of a business is being transferred/sold/gifted a discount might not be applied as its already determined as marketable, leading to an overvaluation of the business. Hence a business appraiser should in fact consider the illiquidity of the company and apply an appropriate discount. There are quality, well known, and accepted empirical studies to demonstrate this discount for lack of liquidity on 100% controlling stakes in privately held businesses such as the Koeplin, Sarin, Shapiro study, the follow up study by Block, and the De Franco et al study.

What assets are non-marketable and illiquid?

An example of a non-marketable and illiquid asset will be a 10% non-controlling interest in a privately held business. The reason being is that there are very limited markets where a non-controlling interest in a privately held business can be sold. Additionally, since there is no readily available market, this asset will take longer to be sold, hence being an illiquid asset as well. Consequently, the discount applicable to a non-marketable asset is usually higher than the discount applicable to an illiquid asset.

Conclusion

Discounts play a significant part in the valuation of closely held businesses as the discounts can be as high as 70% of the total equity value. Imagine a $10 million business, of which a 20% equity interest you see as $2 million, in an actual fact, with correct application of discounts of 50%, the value is actually $1 million. There is a close relationship between marketability and liquidity, but both should not be used interchangeably because the lack of one does not necessarily mean that lack of the other. Furthermore, the discount applicable to a non-marketable asset is different than the discount applicable to an illiquid asset; therefore, using both terms interchangeably can lead to the non-application of a discount or a wrongful determination of it.

Its important to consult an expert accredited business appraiser to determine the appropriate discounts applicable to a privately-held business based on the unique case facts presented in the business. An inappropriate determination of discounts can increase the likelihood of an IRS audit, hefty penalties, improper taxation (including overpayment of taxes), overpayment of equity interests, or DOL investigations for improper sale of stock to the ESOP trust.

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What are Intangible Assets?

Intangible assets are non-physical assets that are valuable to a company. These can include things like intellectual property, brand recognition, copyrights, customer lists, and even employee knowledge and expertise. While intangible assets don’t have a physical presence, they can be just as valuable as tangible assets, if not more so. For example, a company’s brand reputation can be a major factor in its success and profitability.

Why Do Intangible Assets Need to be Valued?

Valuing intangible assets is essential for a number of reasons. First and foremost, it helps companies understand the true value of their assets and can be useful for a number of purposes.

Valuing intangible assets is important for financial reporting purposes. In many cases, companies are required to report the value of their intangible assets on their financial statements. This information is used by investors, creditors, and other stakeholders to assess the company’s financial health and to make informed decisions about whether to invest in the company or extend credit to it.

One of the main reasons that intangible assets need to be valued for financial reporting purposes is to ensure that the company’s financial statements accurately reflect the value of the company’s assets. This is important for a number of reasons, including compliance with accounting standards and regulations, and to ensure that financial statements are free from material misstatements or omissions.

Valuing intangible assets is also important for tax purposes. In many cases, companies can claim tax deductions for the amortization or depreciation of their intangible assets. However, in order to do so, they need to be able to accurately value these assets. If a company overvalues its intangible assets, it could lead to a lower tax liability than it is entitled to, which could result in penalties and interest charges.

In addition to financial reporting and tax purposes, valuing intangible assets is also important for internal decision-making purposes. By accurately valuing their intangible assets, companies can make informed decisions about how to allocate resources and invest in their operations. For example, they may choose to invest in a particular product line or market segment based on the value of their brand recognition or customer relationships in that area.

Why Are Intangible Assets Harder to Value Than Tangible Assets?

While valuing tangible assets is relatively straightforward, valuing intangible assets is much more challenging. One reason for this is that there are often no clear market prices for intangible assets, making it difficult to determine their value. Additionally, the value of intangible assets can be highly subjective and may depend on a wide range of factors, such as market conditions, competitive landscape, and industry trends.

Valuing intangible assets often requires the expertise of professionals with specialized knowledge and experience in business valuation. These professionals can use a variety of methods to value intangible assets, including cost, income, and market-based approaches.

Over the past few decades, the total value of companies has shifted from being primarily based on tangible assets to intangible assets. This shift is largely due to the changing nature of the economy, as many businesses are now focused on knowledge and information-based activities rather than physical goods. As a result, intangible assets such as intellectual property, customer relationships, and brand recognition have become increasingly important for businesses. In fact, recent studies have found that intangible assets now account for a larger percentage of the total value of companies than tangible assets. This shift in value has important implications for how companies are valued and how they manage their assets, and underscores the importance of properly valuing and managing intangible assets.

In conclusion, intangible assets are an important component of a company’s overall value and should not be overlooked when valuing a business. While valuing intangible assets can be challenging, it’s essential for companies to do so in order to understand the true value of their assets, make informed decisions, and take advantage of tax benefits. If you’re unsure how to value your company’s intangible assets, consider seeking the help of a professional business valuation expert.

The post Intangible Definition – Intangible Assets & Business Valuation appeared first on Intelek Business Valuations Australia.

To achieve a consistent and reliable approach to fair value measurement, the Financial Accounting Standards Board (FASB) created ASC 820, also known as the Fair Value Measurement standard. In this article, we will explore the definition and meaning of ASC 820, as well as the main valuation purposes for which it is used.

What is ASC 820?

ASC 820 is a set of guidelines and principles for measuring fair value in financial reporting. It provides a framework for determining the fair value of assets and liabilities, including financial instruments, real estate, and intangible assets. The standard aims to establish a consistent and transparent approach to fair value measurement, promoting consistency and comparability in financial statements.

Definition of Fair Value

According to ASC 820, fair value is defined as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” This definition emphasizes that fair value is based on market expectations and assumes a hypothetical transaction between two willing and knowledgeable parties.

Main Valuation Purposes for ASC 820

ASC 820 is used for a variety of valuation purposes, including:

Financial Reporting

One of the primary purposes of ASC 820 is to provide guidance for financial reporting. The standard requires that companies report fair value measurements of their assets and liabilities in their financial statements, which ensures transparency and consistency in financial reporting.

Mergers and Acquisitions

ASC 820 is also essential for mergers and acquisitions, where companies need to accurately determine the value of the assets and liabilities being acquired or sold. Fair value measurements provide a reliable basis for pricing and negotiating transactions, which is critical for achieving a successful outcome.

Impairment Testing

Another significant use of ASC 820 is in impairment testing, where companies need to determine whether their assets are impaired and, if so, the amount of the impairment. Fair value measurements provide a reliable basis for determining the recoverable amount of assets, which is necessary for assessing impairment.

Tax Planning

Finally, ASC 820 is essential for tax planning, as companies need to accurately determine the fair value of their assets and liabilities for tax purposes. Fair value measurements can impact the tax liability of companies and can provide valuable tax planning opportunities.

Conclusion

In conclusion, ASC 820 is a critical standard for fair value measurement, providing guidance and principles for consistent and transparent valuation. The standard is essential for financial reporting, mergers and acquisitions, impairment testing, and tax planning, and helps ensure that companies use a reliable and consistent approach to fair value measurement. By understanding the definition and meaning of ASC 820 and fair value, businesses can make better-informed decisions and achieve their strategic goals.

The post Definition and Meaning of ASC 820: Understanding Fair Value Measurement appeared first on Intelek Business Valuations Australia.

One of your most valuable assets is your business, and understanding its value is crucial for making informed decisions about its future—meaning your future. Impacted by the success of your business are your time and emotional investment, fulfillment, and, at the end of the day, the future wealth of you and your family. In this article, we’ll specifically mention four valuation purposes whereby understanding what your business’ value is today and what drives this value, will allow you to take action.

This action could mean:

1. saving millions in taxes on your estate plan
2. giving a much higher success probability to a business expansion, or shutting down underperforming business lines that were set to cripple your company
3. offering an employee stock option plan, saving your best staff from leaving while providing a liquidation event for you
4. affording you enough time and direction to significantly reduce the risks within the business, and increasing its value in time for sale (be it for retirement or a sea change)

In all these examples, what is the basis or main value from performing a quality business valuation? Answer: minimizing the associated risks. As with most things, having little or inaccurate information increases your risk of poor decision making. When it comes to your most valuable asset, making decisions hastily or incorrectly is something you simply can’t afford. Not just because of the financial damage, but also due to the emotional damage and loss of time, all of which will doubtless have you lamenting “what could have been”.

As you reach the pointy end of these situations in which an external party is scrutinizing the business value—be that the IRS, DOL (Department of Labor), SEC, or a potential buyer—the derived value and the valuation report must be able to withstand that scrutiny. If it doesn’t, whether due to poor execution, inaccuracy, unsubstantiated assumptions, and so on, this can lead to audits, investigations, penalties, improper taxation, and deal losses, any and all of which can cost you hundreds of thousands or even millions of dollars and heartache.

Regardless of the life cycle stage or situation you find yourself and your business in, there are four main valuation purposes that should be immediately considered, evaluated, and ultimately acted upon.

Estate Planning

“Isn’t estate planning only for when I’m about to die?” This is a common misconception. Your estate, though passed onto a party or entity of your choosing when you die, obviously exists while you’re living, too. It’s an evolving legal representation of your ownership and wealth, which for maximum performance should certainly be managed properly while you’re still alive. It shouldn’t be considered solely when you’re on your death bed. Worse still is leaving your estate planning unmanaged until after death, which will cause significant time—as well as emotional, legal, and financial pain—for those left behind.

Taking action and working with your advisors will help lead to proper corporate structures, which limits your legal and tax exposure. As part of this process, your advisors will need to conduct a business valuation, and should do so as early as possible. Ideally, it should be handled when the value of the business is lower than what it will be in future years at the time of death or transition of wealth to another party or parties. This will allow the tax assessment to be conducted on the lower yet accurate amount. If the proper corporate structures and quality valuation have not been conducted, the IRS can easily take up to half of the estate’s value in taxes, and then you’re in an “it’s too late” situation.

You want to minimize this risk through quality advice and proper, well-substantiated valuation. Correct corporate structures but poor-quality valuation still invites the IRS to audit, investigate, and apply penalties and fines—not to mention the fees you’ll need to pay enduring the ordeal.

A complete guide to valuation for estate planning can be found here in this e-book.

Strategic/Exit Planning

Another key reason to understand the value of your business is for strategic planning purposes. This has the same underlying idea, in that knowing the accurate value of your business provides you with quality information with which you can make informed decisions. This then lowers your risk of making poor choices and experiencing negative outcomes, be they financial or otherwise. Often with strategic planning or exit planning, a full appraisal report is not required— not at this point anyway.

We often start with an exploratory report which, as the name suggests, explores information to uncover options and possibilities. A state-of-the-art valuation process is still implemented as-is for the full appraisal—however, you don’t get the lengthy report, because outside scrutiny from regulatory agencies isn’t occurring. This exploratory report provides several things other than the value itself, which is always presented as a valuation range, in which we discuss the reasons why that can put you at the bottom, top, or middle of that range. During the assessment of the business, a full risk analysis is completed, and an understanding is gained of what the value drivers of the business are. All this information then lets you evaluate your goals and options. Do you want to undertake an expansion, and can the business afford that? Should underperforming business lines be closed or restructured? Do you need to look for external investors or bank financing? Or maybe this is the opportune time to initiate an ESOP?

Strategic planning then ultimately leads to exit planning. Eventually, we all exit from our businesses, which is why estate planning (as mentioned previously) is crucial. The exploratory report then turns into a full appraisal for when submissions to the IRS, DOL, or often potential buyers are required. Withstanding the outside scrutiny, this is where the state-of-the-art process and comprehensive report delivers an extremely defensible value.

Without the knowledge, your options are more limited.

ESOP

An ESOP (Employee Stock Ownership Plan) is a way to give employees an ownership stake in the company in a way that is very tax favorable to both the owner and employees. It’s also a qualified retirement plan for the owner. This can be a great way to attract and retain top talent; the employees gain motivation and alignment with the company because they share in the profits in a tax advantaged manner, while liquidating a portion of your shares (as determined by you) at attractive levels with tax incentives as the owner and still being involved in the company at an operational or strategic level. There are several benefits to an ESOP for a) the employees that buy into the company, and b) the owner, who is transitioning the company into this new ownership structure.

As you can imagine for such a situation in which employees (who are probably unsophisticated investors with no experience as business owners buying into the business), the government and the relevant regulatory institutions have strict and very specific laws, regulations, and policies. These policies ensure the employee’s financial well-being is protected (to a certain level) through this process, and rightly so. This creates a large amount of risk around the validity and veracity of the valuation of the company and the common share value. This is because it will be highly scrutinized by the DOL and IRS in order to protect the employees, ensure they are fairly compensated, and mandate that the correct taxes will be paid.

Below, an oversimplified explanation of how this functions:

• an ESOP trust is established, which will be the vehicle to buy the shares of the company
• this trust appoints a trustee (an accredited trustee, of which there are few in the country) who manages all the undertakings on behalf of the trust and essentially the employees’ ownership of the company
• the trustee appoints an accredited appraiser to conduct a valuation of the company and the share value under a fair market value standard
• once the valuation has been accepted by the trustee and the trust has acquired the appropriate funding to make the purchase, the purchase can be made

The valuation must stand up to the highest levels of scrutiny. As a result, the trustee will use an accredited appraiser who has the correct accreditations and experience. They will be able to prove their state-of-the-art valuation process, customizable to the specific case facts, to arrive at the conclusion of value, which will be well-substantiated within the valuation report. This will be what’s ultimately submitted to the Department of Labor (“DOL”) and IRS.

At InteleK, we undertake ESOP transaction and review valuation engagements with the highest level of independence. In addition, we acknowledge the situational importance of ESOPs to the various stakeholders involved. We apply our state-of-the-art valuation process that’s built on robust, well-established methodologies from a sophisticated legal and financial basis, in which the data drives the value, both qualitative and quantitative. This process derives unmanipulated and highly defensible conclusions of value.

Sale Preparation

If you’re planning to sell your business, it’s essential to have a clear understanding of its value. Again, if you’re not armed with this information, you’re at a higher risk of making poor decisions that will negatively impact you, financially or otherwise. An accredited appraiser conducting a valuation will provide you with the value (most beneficial for this purpose to be a value range), clearly identify the risks (on a sliding scale of high to low), and explain what the main drivers of value are. What the appraiser should also do, as we do with our clients, is speak to what will push the business to fall at the top, bottom, or middle of that range. This enables you to work with your advisors to have the correct legal structures, operational improvements, and risk minimization, preventing a potential buyer from paying less than what’s desired.

During the initial valuation (again, an exploratory report is the best way forward as the first step), there are several items uncovered that can impact the business’ value negatively. These things are identified, as well as what impact they have on the value. If found early enough, they can be fixed before the sale needs to be made. In other words, problems are mitigated when you still have enough emotional energy to do so, not before it’s “too late”. Some common examples:

• Lack of financial records: if the company doesn’t have up-to-date financial statements and other accurate records, it will be difficult for a buyer to perform due diligence and have confidence in the company’s financials
• Legal and compliance issues: if the company isn’t in compliance with relevant laws and regulations, it can make it more difficult to find a buyer, and can also lead to potential liabilities and penalties
• Tax issues: if the company hasn’t done proper tax planning, the sale of the company can result in a significant tax burden, which can make it less attractive to buyers
• Weak management team: if the company doesn’t have a strong and stable management team in place, it can be difficult to find a buyer who’s confident in the company’s ability to continue to perform well after the sale
• Poor market positioning: if the company hasn’t taken steps to position itself as an attractive acquisition target, it can be difficult to find a buyer who’s interested in the business
• Lack of growth strategy: if the company doesn’t have a clear and compelling growth strategy in place, it can be difficult to find a buyer who’s interested in the long-term potential of the business
• Timing: waiting too long to prepare for a sale can make it difficult to find a buyer when market conditions are favorable and the company is performing well

Overall, preparing a company for sale takes a fair bit of time and requires a lot of work. It’s important to start planning early so that the company is in the best position possible to attract the right buyer at the right time.

Extra info: once you’ve successfully sold the business, there will be submission of valuation reports for tax and financial reporting purposes. These will require a full appraisal report of high quality to be able to withstand the outside scrutiny.

Conclusion:

Understanding the value of your business is essential for minimizing your risk, which isn’t simply limited to when a valuation report needs to withstand outside scrutiny. It also comes down to minimizing the risk of poor decision making—ones that cost you thousands or millions of dollars—not to mention the heartache and loss of time. Whether you’re planning your estate, making strategic decisions, preparing for a sale, or considering any number of other valuation purposes, finding a credible and quality appraiser will be well worth the investment.

Don’t wait until it’s too late. Act now and protect your wealth and legacy.

The post Act on Your Business Value Before it is Too Late appeared first on Intelek Business Valuations Australia.

A reasonable cost of capital calculation hinges on accurately assigning a risk-free rate and equity risk premium to the model. While both are less prone to analyst-specific subjective criteria, there is still nuance to each. Both are moving targets, and analysts must weigh variables feeding the components closely to determine the most accurate estimate.

Luckily, broadly accepted data sources feed each determination. Still, diligent assessments weigh conventional wisdom, project or company specifics, and a bit of predictive power that external factor forecasts with historical precedent.

Risk-Free Rate

Risk-Free Rate Defined

The risk-free rate is the return investors, or companies would generate if they parked cash in a riskless asset rather than the potential project or investment. Nothing in life is guaranteed, and investment returns aren’t an exception. Therefore, risk-free is a misnomer, but the typical proxies are as close to riskless as is practical for an investment.

The return used as a proxy for a risk-free rate is typically the yield of a reliable government’s bond issues. Global analysts often use US Treasury yields as the risk-free rate. Other debt instruments, like corporate bonds, carry an inherent default risk no matter the firm’s stability. Government-issued bonds, though, are all but guaranteed.

If the United States cannot fund coupon payments for bonds issued today in ten years, they could raise taxes to bridge the difference. If the country does default on outstanding bond debt, there are much more significant concerns than fixed-income payments. So, US Treasuries are the most viable proxy for a return on a riskless investment – but which are appropriate?

Time Horizons Matter

Technically, short-dated T-Bills maturing between 4 and 52 weeks are the safest return guarantors. But they’re rarely used as a proxy in cost of capital calculations. Because analysts measure investments and company projects in terms of years and decades rather than months, longer-term Treasury Bond yields act as the rate to measure the expected return of a riskless investment over the same period.

When generating a cost of capital estimate, risk-free rates are usually assumed to remain fixed throughout the investment and don’t fluctuate with market conditions. The rate assumes the buyer purchases bonds today to generate income rather than active trading in secondary debt markets. Therefore, the risk-free rate is susceptible to today’s economic conditions but not impacted by unforeseen future events.

A Better Rate of Return

As the Federal Reserve hikes or cuts interest rates, the risk-free asset’s return follows suit. Government bonds become less attractive when interest rates fall as they generate less return. Reduced income payments increase investor interest in riskier projects. The opposite also holds. If the Federal Reserve sends rates skyrocketing, investors are guaranteed a return they’re happy with and will demand a higher return from alternate investments.

Often, companies seeing the prospect of high risk-free rates forego new projects. Additional risk factors coupled with a hefty, guaranteed return make the overall cost of capital too high to hurdle. Companies may elect to invest the money allocated to that project in the risk-free asset and wait for conditions to change.

Equity Risk Premium

The equity risk premium is the return investors demand for the increased risk of investing in the broad public market rather than the risk-free rate. Since returns in the market vary, and there is potential for losing substantial funds, investors expect extra compensation for their capital. Combined with the risk-free rate, that percentage is the market risk premium.

What’s the Difference?

The equity risk premium is the difference between the expected return of the market and the risk-free asset. But there is important nuance when pinning down the expected market return to feed the ERP calculation.

There are two ways to estimate the expected market returns:

Ex-post Approach

The most straightforward (mathematically) way of finding an ERP, the ex-post approach is a function of simple or compounding returns over a selected historical period. The primary variance in the final ERP is via selectively picking the period, but analysts should otherwise come up with similar ERPs if all else is equal.

If determined to arrive at a specific ERP, an analyst can manipulate the ERP to influence a project by selectively picking the period. For example, the US market return since inception is around 6.5%. But discounting the effects of the Great Depression boosts the return closer to 9% and dictates a higher ERP.

Forecasters can argue that the Depression was a one-time black swan event whose inclusion skews the actual data and that better returns over time in the market dictate a higher return from alternate investments. Likewise, analysts can shift the ERP by moving the time window to include or exclude events like the Dot-Com Crash and 2008’s Great Recession. Investors who argue that the post-2008 paradigm is the new order moving forward will calculate market returns closer to 14%.

These perspectives vary across firms and individuals, so clients should ensure that the model discloses the ERP’s time window when reviewing the cost of capital calculations.

Supply Side vs. Historical Inputs

Often, the least complicated return calculation, and what we referenced above, is a retrospective view of market returns generated by holding shares in a company. But in addition to the selective timing window, this method also over-relies on pattern recognition that may break down in the future.

Alternatively, stock market returns can be replaced with economic returns. When executed correctly, this method is more accurate, but more difficult to quantify. When done correctly, the model negates the effect of forward-looking earnings expansion expectations inherent in stock pricing. Because it deflates the stock price, the final ERP is often lower than historical return ERPs.

Ex-ante approach

More art than science, the ex-ante approach uses analyst’s forecasting models to predict the expected future stock prices and dividend distributions based on today’s information. More complex because of more inputs, ERP will vary drastically from analyst to analyst, dependent upon their perspective and biases. Furthermore, research indicates that current economic conditions weigh heavily and disproportionately impact the analysts’ perspective. Because of this, an analyst calculating the ERP in 2008 would have a very different outlook on the future than one doing the same in 2021. This psychological shortcoming further muddies the waters in an already subjective approach.

Regardless of the selected approach, many fine details must be accounted for when calculating an ERP, and amateurs often find themselves in a “paralysis by analysis” scenario; they cannot pin down an ERP accurately.

The post Cost of Capital Method Components: Risk-Free Rate & Equity Risk Premium appeared first on Intelek Business Valuations Australia.