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Valuing a Small Business

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Valuing a Small Business

For a large public company, the share price on the stock exchange can be used as an indicator of the company’s value. Comparable public company multiples can be used to compare the subject company’s valuation. However, applying trading multiples of large companies in a similar industry to small companies is not a reasonable measure of the company’s actual worth. A more acceptable method for valuing a small business is earnings and cash flow valuations. Cash flow valuation utilizes capitalization and discount rate; both of which are a function of cost of capital that is the cost of funds used for financing a business. The discount rate is used for a discounted cash flow valuation whereas the capitalization rate is used for capitalized cash flow valuation.

Weighted Average Cost of Capital (“WACC”) is the appropriate discount rate used for discounted cash flow valuations. It is the cost of the following capital components: the cost of equity and the after-tax cost of debt multiplied by its proportional weight.

Secondly, accurately deriving the cost of equity can be tricky. The most common approach used by many small, private businesses to value a small business in Toronto is the build-up approach that is the sum of risk-free rate, equity risk premium and an industry premium. Alternate approach to this is the CAPM model, which is often used by larger, public companies. The CAPM model describes the relationship between beta (systematic risk) and expected return. Systematic (market) risk is due to factors, such as GDP growth and interest rate changes, that affect the values of all risky securities. These risks cannot be reduced by diversification whereas unsystematic (firm-specific) risk can be reduced by portfolio diversification. Furthermore, the underlying assumptions in the CAPM model suggest that the portfolio diversification to eliminate unsystematic risk is costless; investors cannot increase expected equilibrium portfolio returns by taking on firm-specific risks. However, in practice that is not true. Therefore, modifications need to be made when calculating the cost of equity by adding size premium and specific company premium.

This leads to another very important point, small firm effect or size effect for valuing a small business. Recent studies show that when comparing smaller companies to larger companies, there is greater risk that exists in smaller companies, which essentially means higher returns on equity and as a result higher cost of capital. This is because the beta in the CAPM model only measures the market risk and not firm-specific risks based on size such as lack of liquidity, higher default risks, lack of pricing power and more. Hence, a company’s unsystematic risk should be reviewed carefully and incorporated accordingly when calculating the cost of equity in a small business valuation.

In conclusion, to sufficient small business valuation starts from carefully determining the cost of equity by making sure both market and firm-specific risks are captured in the calculation. This will lead to a more accurate calculation of WACC and as result arriving at true cost of capital.

 

 

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