Understanding Risk in Business Valuation

Summary

In this episode of Forensic Perspectives, host Mark Connolly delves into the complexities of risk and business valuation. He explains the various factors that influence a company’s valuation, such as business, financial, and liquidity risks, and highlights the importance of understanding specific company risk drivers. The podcast explores how risk is assessed in business valuation, particularly in the context of closely held businesses, and provides insight into common pitfalls like duplicating risks in different parts of the valuation model. This episode is aimed at attorneys and others working with forensic accountants, offering a clearer understanding of risk assessment in business valuation.

Takeaways

• 😀 The Forensic Perspectives Podcast discusses key topics in forensic accounting, business valuation, economic damages, and litigation support.
• 😀 The recent $4 billion acquisition of Marvel by Disney is highlighted as a major business event with uncertain benefits for Disney's shareholders.
• 😀 Disney's purchase of Marvel includes over 5,000 characters, with assets spread across various media and businesses like licensing, publishing, and film production.
• 😀 Valuation multiples, particularly the capitalization rate, are crucial in business valuation and reflect a company's specific risks.
• 😀 Company-specific risks must be assessed when valuing a private company, considering factors like management depth, product/service diversification, and geographic location.
• 😀 Business risk refers to factors that could prevent the realization of forecasted earnings, including sales, cost of sales, and operating expenses.
• 😀 Financial risk focuses on how a company is financed, with higher debt increasing financial risk and potentially lowering pre-income earnings.
• 😀 Liquidity risk in business valuation refers to challenges in selling a company's interest, particularly in closely held businesses, due to longer timeframes for liquidation.
• 😀 Unlike business and financial risk, liquidity risk does not impact income realization but is an issue for investors seeking to exit a business.
• 😀 The subject company's risk analysis plays a critical role in a valuation report, with attorneys needing to focus on these principles to challenge or validate a valuation conclusion.
• 😀 The aggregation of specific risk premiums in closely held businesses significantly affects the final valuation, and care must be taken to avoid duplicating these risks in other valuation components.

Q & A

What is the primary topic of today's discussion on the forensic perspectives podcast?

The primary topic of the discussion is understanding risk and business valuation, particularly focusing on how risk is evaluated in business transactions and the factors involved in business valuation.

How did Disney's acquisition of Marvel in 2009 relate to business valuation?

Disney's acquisition of Marvel involved a high risk business transaction where Disney paid a significant premium above the valuation of Marvel's assets. The risk in the deal raised questions about how accurately Marvel's value was assessed and how it would impact Disney's long-term financial performance.

What are the key factors that influence the valuation multiple in business valuation?

The valuation multiple is influenced by various factors, including the company's specific risk, which is based on a number of factors like management depth, importance of key personnel, industry stability, and geographic location, among others.

What are the three main types of risks discussed in the context of business valuation?

The three main types of risks discussed are business risk, financial risk, and liquidity risk. Business risk relates to factors impacting sales and expenses, financial risk is linked to interest and debt, and liquidity risk concerns the ability to liquidate investments.

What does business risk encompass in a business valuation?

Business risk encompasses factors that may prevent the realization of forecasted earnings, including variables like competition, management quality, industry conditions, and working capital.

How does financial risk affect a company's valuation?

Financial risk affects a company's valuation by considering the impact of interest expenses and debt on forecasted earnings. A company with high debt levels faces higher financial risk, which can significantly impact its valuation.

What is liquidity risk, and how does it differ between closely held businesses and publicly held businesses?

Liquidity risk refers to the uncertainty of selling an investment at fair market value. In publicly held businesses, liquidity risk is low as shares can be sold quickly. However, in closely held businesses, liquidity risk is higher due to the challenges in selling shares in a private market.

What role does risk play in the capitalization rate in business valuation?

Risk is a critical component in determining the capitalization rate, as it reflects the additional return required to compensate for the specific risks associated with a company. These risks are factored into the valuation multiple and influence the final business valuation.

What is the potential impact of an inaccurate risk evaluation in a business valuation?

An inaccurate evaluation of risk can lead to incorrect business valuations, which can negatively impact decisions related to mergers, acquisitions, or investments. It can also expose the valuation to challenges from adversaries in legal or business disputes.

How can an evaluator articulate the company's risk factors in a business valuation report?

An evaluator can articulate risk factors by thoroughly analyzing the company's industry, management, financial components, and external economic factors, and presenting a clear explanation of how these factors influence the valuation conclusion.