There’s a trade-off between risk and return in business valuation. Investors expect to receive a higher return as the company exposes them to greater risk. Industry-specific risk is an important consideration when estimating an investor’s expected return. Our affiliate company, MFA Global, recently shared the following article which explores how business valuators measure industry risks and factor them into their analyses.
Assessing industry risks
Virtually every business valuation report includes a section on industry risks. Several factors are used to measure industry risk, including:
- Growth prospects. Evaluate the industry’s future outlook, including its seasonal and cyclical trends and stage of development. For example, emerging industries typically grow faster but face greater uncertainty than mature industries. Strong, predictable growth prospects generally equate with lower industry risk and higher value.
- Relative power of suppliers and customers. Look up and down the company’s supply chain to determine which players have the greatest negotiating power. For example, the subject company may be at the mercy of vendors if it operates in an industry dominated by a few key suppliers that provide value-added services (as opposed to price-sensitive commodities). Supply chain partners with more power or supply chains with unbalanced power tend to characterize a higher industry risk profile than those where the balance of power is in favor of the company.
- Competitive threats. When sizing up the competition, consider geographic location and market position. For example, you obviously wouldn’t compare a fast-food taco truck to an upscale five-star restaurant. Large industry segments characterized by intense global price competition are particularly risky.
- Risk of product substitution. Evaluate whether customers could use another readily available, less expensive product in lieu of the subject company’s offering. If customers can easily switch to a substitute product, the industry’s risk is greater.
- Industry complexity. More is at stake when companies participate in industries that require licensing, expensive outlays for equipment, compliance with stringent regulatory requirements, and continual investments in technology or research and development. To illustrate, investors typically demand a higher return for investing in a high-tech manufacturer than in an educational services provider.
Valuators use several resources to assess industry risks, including the company’s business plan, industry trade associations and fee-based external sources.
Factoring industry risk into value
Once a valuator understands the subject industry, he or she can evaluate management’s cash flow predictions. For example, a valuator may question how realistic it is for management to forecast a 10% growth rate if the industry is declining and management hasn’t taken steps to transition the company’s offerings to changing consumer demands.
Likewise, when selecting comparables from public stock markets or private transaction databases under the market approach, it’s important to know where the subject company fits within its industry in terms of size, financial performance, capital structure and market position. Some comparables may be eliminated based on the industry risk assessment — or an industry-based risk adjustment might be factored into the valuator’s application of pricing multiples.
Under the income approach, the company’s discount rate (also known as its required rate of return) may be adjusted up (or down) depending on how risky the company’s industry is compared to the overall market. This adjustment can be made if the appraiser uses the capital asset pricing model or the build-up method to estimate the subject company’s discount rate.
Also, under the income approach, industry risks come into play when estimating the company’s long-term sustainable growth rate. Valuators generally assume that the subject company’s growth will someday even out to a moderate, steady rate into perpetuity. In turn, this growth is used to compute capitalization rates under the income capitalization method and terminal value under the discounted cash flow method.
Getting a handle on industry risks
Industry risks impact the value of a business in many subtle ways. Accurate valuations hinge on taking the time to thoroughly understand the subject industry and where the subject company fits within that group. For more information, contact us today.