Business operations are subject to a number of risks from both internal and external factors. In addition, ownership interests in businesses are subject to risks, including market factors. How organizations and their owners address these risks can have a significant impact on the value of businesses and interests therein.
An enterprise risk management (ERM) process involves identifying risks relative to an organization’s objectives, assessing them for likelihood and impact, developing a response strategy and monitoring progress. A well-defined ERM framework can protect and create value for the organization and its owners.
“How a business addresses risk can have a significant impact on the value of a business,” says John T. Alfonsi, CPA, ABV, CFF, CVA, CFE, a managing director of Cendrowski Corporate Advisors LLC.
Smart Business spoke with Alfonsi about business risks and how they impact valuation.
Where is risk addressed in a business valuation?
The most common method of valuing a business is the ‘income approach,’ which requires a valuation analyst to project a business’s future cash flows, then calculate the present value of the sum of these cash flows by employing an appropriate discount rate.
When using the income approach, a valuation analyst must address risk in two primary areas: projected future cash flows and the discount rate. Effective ERM processes can help businesses increase value by affecting the estimates for these quantities.
How does risk impact projected future cash flow?
Projections contain risk: There exists a risk that the organization will not achieve the projected figures. As such, the process by which management projects future cash flows can impact a valuation analyst’s assessment of the business. A key risk in the process is information integrity, the quality of information generated through monitoring and data assimilation. Information integrity allows management to make well-informed decisions and should provide a valuation analyst with greater confidence in a business’s projections.
Valuation analysts can analyze information integrity by examining historical projections and assessing elements of the internal control environment. In analyzing historical projections, a valuation analyst should examine the variance between historical projections and a business’s actual performance. If a strong correlation exists, a valuation analyst can be highly confident in current projections, if the process employed by the organization in making projections remains constant. If a strong correlation does not exist, the analyst must examine the variance between past projections and actual performance to discern whether bias existed in past estimates and may exist in current projections. While valuation analysts are not experts in assessing internal controls, they can question management regarding how information integrity is maintained and business risks are assessed.
What about risks in the discount rate?
The discount rate is the yield necessary to attract capital to a particular investment, given the risks associated with that investment. A project with relatively high risk will require a relatively high yield to compensate an investor for bearing these risks. In determining the discount rate, there are two sources of risk to be quantified: systematic and unsystematic. Systematic risk is the risk one must bear for taking on a risky investment in the market, which encompasses all available risky investments, including public and private equities, real estate, foreign currencies, etc. However, systematic risk is estimated by calculating the return to public equities due to availability of data. The ERM process has little impact on systematic risk unless the business’s performance is heavily tied to market performance, as was the case with Lehman Brothers and Bear Stearns in their final days.
Unsystematic risk is sometimes broken down into two components, industry risk and company-specific risk. Industry risk reflects the risks identified with the industry in which a business operates. Company-specific risk encompasses all other risks, including (but not limited to) size, depth of management, geography of operations, customer and/or vendor concentration, competition and financial health. This last component of the discount rate is one that businesses can impact, and commensurately increase or decrease their valuation. Identifying and minimizing company-specific risks through an ERM process can positively impact the value of a business, as a company subject to less risk is more valuable than one subject to greater risks.
Are there risks that businesses can manage and some they cannot?
Yes. Businesses cannot generally control systematic risk. They can, however, control company-specific risks. Successful identification, analysis and mitigation of company-specific risks through effective ERM processes can commensurately bolster a business’s valuation.
How can ERM processes mitigate company-specific risks and increase value?
An ERM process should quickly gather and assimilate high-quality information for use in the organization’s decision-making process, allowing the organization to rapidly assess the impact and likelihood of risks associated with changes in its internal and external environments. Early assessment and mitigation can help preserve value and capitalize on risky events when competitors do not react as swiftly to environmental changes. By capitalizing on risky events, businesses increase the chance of improving market share or maintaining an industry-leading position. ERM processes can also provide resilience to events including the loss of a leader or key customer. The ability to successfully mitigate risky events should be recognized by a valuation analyst through lower estimates for company-specific risks, leading to higher valuation estimates.
John T. Alfonsi, CPA, ABV, CFF, CFE, CVA, is a managing director of Cendrowski Corporate Advisors LLC. Reach him at (866) 717-1607 or firstname.lastname@example.org.