Factoring Uncertainty into the Value of Your Business
Businesses currently face numerous uncertainties in the marketplace. As President Trump and Republican congressional leaders work toward fulfilling their campaign promises, tax laws could substantially change, the estate tax could be repealed, and various laws and regulations (including the Dodd-Frank and Affordable Care Acts) could be repealed or revised. Interest rates and inflation could both rise. Economic relationships with other countries could also change. Some of these changes could be good for your business, while others could have negative effects on the value of your business.
Business valuation professionals are no strangers to dealing with market uncertainties — and neither are business owners and investors. The approach to valuing a business interest doesn’t change because of the uncertainties surrounding the current political environment.
Under the market and income approaches, the value of a business continues to be a function of expected economic returns and market, industry and specific company risk. These fundamentals didn’t change during other events that caused uncertainty earlier in the 21st century, such as the terrorist attacks on September 11, 2001, or the Great Recession that lasted from December 2007 to June 2009.
Here are some considerations when valuing a business in today’s volatile political climate.
Public market returns. The inputs that valuators use to determine discount rates and pricing multiples are typically based, in part, on data from the public stock and bond markets. So far, public markets have reacted to the election results in a positive manner. In general, the proposed changes to taxes and business regulations are likely to lower expenses and increase cash flow for many businesses.
Company-specific risks. A factor that has changed substantially is the risk associated with specific companies and industries — and valuators face challenges as they attempt to measure these risks. For example, proposed regulatory changes might increase the value of companies that operate in the energy sector or the manufacturing sector. On the flipside, they might adversely affect the value of companies that operate in the government contracting or health care sectors.
Known (or knowable) information. Many private business valuations are prepared with a year-end effective date, because it corresponds to the cut-off date for their annual financial statements. Valuation experts can only use information known or knowable at the date of the valuation. But what did we know as of December 31, 2016?
Valuation experts constantly monitor market conditions. Realistically, at the end of 2016 and even today, there are many unknowns. The specific details of tax reforms and other regulatory proposals haven’t been fully put into effect or made into law. Since we can only speculate on what will happen in the future, business valuators must focus on the likelihood that the subject company will achieve its expected future income. The risk that a company won’t meet its financial forecasts is factored into its discount rate.
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Experienced appraisers understand the importance of reacting to events that cause added uncertainty with an objective, measured response, rather than a knee-jerk response. In today’s marketplace, they understand that politicians have many divergent plans that may (or may not) be approved or take effect.
In the meantime, business owners and investors should stay calm and carry on. A valuation professional can help you stay atop the latest tax and regulatory changes and understand how they could impact your company’s expected return and risk profile in the future.
Public Markets Respond to the Election Results
Following the election and through the end of 2016 — the effective date for many private business valuations — the Standard & Poor’s 500 Composite Stock Price Index, a leading indicator of large stocks, has responded positively.
Specifically, the S&P 500 index increased from $2,139.56 on November 8, 2016, to $2,163.26 on November 9, 2016, an increase of 1.1% from the closing price on Election Day. As of December 31, 2016, the S&P 500 index had risen to $2,238.83, an increase of 4.6% compared to the closing price on Election Day.
It’s important to note that changes in the S&P 500 index aren’t exclusively tied to the election results — and sometimes the market misjudges the impact of major events. However, the performance of the S&P 500 does provide a general indication of investors’ expectations about expected economic returns and systematic risk that can assist in valuing businesses in today’s uncertain marketplace. When valuing small private firms, however, current events in the public markets can be less of a factor than estimating long-term economic income probabilities.