Business operations are subject to a number of internal and external risks, as are ownership interests in businesses.
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 enterprise management process framework can protect and create value for organizations and their owners.
Smart Business spoke with John T. Alfonsi, managing director at Cendrowski Corporate Advisors LLC, about how ERM processes can mitigate risk and increase a company’s value.
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.
The 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 cash flow?
There exists a risk that an organization will not achieve its 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.
A valuation analyst should also 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 remains constant.
If not, the analyst must examine the variance between the past projections and actual performance to discern whether bias existed in past estimates and current projections.
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 that need to be quantified: systematic and unsystematic.
Systematic risk is the risk one must bear for taking on a risky investment in the market. 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 risks unless the business’s performance is heavily tied to market performance.
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 risks encompass all other risks, including size, depth of management, geography of operations, customer and/or vendor concentration, competition and financial health.
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. ●
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