The Degree Of Risk In Your Operations Affects The Value Of Your Company

Understanding the nature of your company is an essential part of obtaining an accurate value. IRS revenue ruling 59-60 emphasizes the importance of understand the company's nature

This revenue ruling goes into more detail by stating, "The history of a corporate enterprise will show its past stability or instability, its growth or lack of growth, the diversity or lack of diversity of its operations, and other facts needed to form an opinion of the degree of risk involved in the business."

Let's look at some factors listed in the previous paragraph and see how they affect the company's value. Risk is a vital factor impacting value. Investors are inherently risk adverse and will accept risk only when the expected rate of return compensates them sufficiently for taking the risk.

Suppose you had a choice of investing a million dollars in Microsoft or a startup software company with only two years of vary unstable earnings. If you expected to receive the same return from either choice, you would be better off investing in Microsoft. They have a longer history of stable earnings and are a safer investment.

A start up company needs to offer a higher rate of return to attact investors. This higher rate offsets the increased risk of the investment.

Professional business appraisers understand this concept when calculating the discount or capitalization rate specific to the company they are appraising. The rate of return is calibrated according to the level of risk inherent to receiving the expected return.

The growth in revenue and earnings are analyzed. A company with a trend of positive growth in both revenue and earnings is more desirable to investors than a company with lack luster revenue growth and declining earnings.

Another factor to be analyzed is the company's level of diversification. A company with many markets, product lines, and customers is less risky than a company with one geographic market, one product and one customer.

I was in Japan a few years ago with some business associates. We visited with the owner of an auto parts supplier. His only customer was the local Toyota plant. I can only imagine his business must be down because of the recession and all the safety concerns Toyota is going through right now. Having only one customer for his business increases his company's risk.

I appraised a business which had one customer who accounted for 95 percent of sales. The business had a written contract with its customer. The contract stated either party could terminate the contract with a 30 day written notice for any reason. Needless to say, this lack of diversification and dependency on one customer increased the investment risk and in turn decreased the value of the business.

Business appraisers consider many factors when they perform an assignment. The factors mentioned in this article are just a few of them.