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Multi-Scenario Valuations

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In these troubled economic times, many businesses face uncertain futures. As states slowly allow more and more businesses to open, there are many questions left unanswered. These businesses will face new regulations concerning how they conduct their business. Customers will be choosing different ways to make purchases.  Supply chains, which have been disturbed, may be vastly altered and competition could arrive from unlikely sources. Significant decisions will need to be made. Some businesses will simply close. Some will look to be purchased. Others will try to start up as before and still others will seek Small Business Loans or other loans to get back on track or to even expand beyond where they were when the shut down occurred.

If a business is considering selling, merging or taking a (non-PPP) loan, management will likely require a business valuation. Since the future is more clouded than usual concerning expected future cash flows, an approach that companies may use is a multi-scenario approach to valuation. In this analysis, as in any valuation, a business appraiser would study a company’s historical performance, typically their previous five years. The valuation analyst will look at the company’s balance sheets and income statements from tax returns or financial statements. This provides a picture of the health of the business.

From these, and with detailed discussions with the business owners, the analyst is able to craft projections which are based upon historical performance and future expectations. However, when circumstances change, adjustments must be made to the financial performance going forward. This could be a result of a company starting a new product line or choosing to expand their operations or from the loss of a large customer. Or, as is currently occurring, a total business disruption. Some industries may be expanding or contracting. This is the normal course of business. However, now there may be very little some companies can do to guarantee success going forward. In many cases their historical performance may not capture their new reality.

A business with positive earnings is usually valued based on two approaches that are earnings based: the Market Approach and the Income Approach. The Market Approach is based on determining certain financial metrics and ratios of the subject company and comparing them to peer companies in their industry. In the current economic environment, most recent historical results are not going to yield reasonable results, because most companies that were not essential businesses (as defined by the government) have had their business cash flow completely disrupted.  Thus, we are left with only the Income Approach.  

So, what is a multi-scenario valuation? Well, it is somewhat self-explanatory. We begin by looking at a company’s historical performance prior to the shut-down. This gives a basis to work from. We then need to look closely at the subject company’s industry, competition and current market conditions. This is difficult due to the potential of existing companies exiting the industry, and others seeing a potential gap to fill or opportunity created and starting a new business line. Due to all these unknowns, we must look at multiple ways a company may perform in the future. We generally would like management to project anywhere from 3 to 5 years of expected cash flow depending on a company’s current growth mode. This can be difficult in the best of times; it is almost impossible now.

How can we posit a more reasonable analysis? We will look at multiple levels of growth and profitability.  By determining at least three scenarios (worst case, base case and best case) we can probe different levels of cash flows to the business going forward.  For example, we will ask for a forecast that you are 90% sure you can achieve (this may be zero revenues and negative income) for the worst case.  For the base case, you should be able to achieve your forecast with 50% surety.  For the best case, there would only be a 10% probability of achieving it. Using these scenarios, we can develop a matrix of results with different revenue growth rates, from sharp declines to sharp increases depending on the specific company’s circumstances.  Then we would calculate expense levels which may result in additional losses or gains. A third key factor is to determine the most applicable risk factors, represented as a discount rate. Generally, a more aggressive projection would require a higher specific company risk premium resulting in a higher discount rate and corresponding lower value. Again, this is driven by current market conditions (if a current valuation), the financial and non-financial condition of the business being valued and the level of growth and profitability that is being projected.

The final result will be a range of potential values which, at least, creates a minimum and maximum value based on the best available information known at the time of the valuation.  Assigning and varying the probabilities assigned to each of the three scenarios, which can change with changing business conditions, can provide a good indicator of your business’ value.

Robert Mulhearn, Sobel EAC Valuations

Robert Mulhearn, CFA, has been providing expert business valuations to Sobel EAC Valuations for more than 5 years.  Prior to his current role, Bob had more than 30 years’ experience in valuation with several companies, including 11 years with Enterprise Appraisal Company, the founding entity to Sobel EAC Valuations.