Under the Income Approach to valuation, maximizing value becomes a function of increasing net cash flow , decreasing an investor’s perception of risk or a combination of both. Last month we discussed various ways to increase net flow and this month we’ll review various ways to reduce investor’s risk. In valuation terms, investor’s risk is also referred to as an investor’s required rate of return or, capitalization rate, and it is expressed as a percentage.
A key component in determining the value of a going concern is the strength and transferability of the business’ cash flow. An investor is likely to pay more for a cash flow that’s predictable than one that is subject to various internal and/or external sources of risk.
The general rule of thumb is “the lower the risk the higher the value.”
Below is a sample of some of the factors we commonly consider when evaluating the strength and transferability of cash flow.
· Company operating history and volatility of cash flow
· Depth and quality of management
· Competition and barriers to entry
· Access to capital resources
· Reliance on key person(s)
· Size and geographic diversification
· Concentration in customer base
· Market resources in light of competition
· Purchasing power and other economies of scale
· Product and market development resources
· Technological obsolescence
· Reliance on vendors
· Distribution system
· Financial reporting and controls
· Long term contracts with customers or unique products or
· Patents, copyrights, franchise rights, proprietary products
· Operating facilities and capital investment needs
· Industry and economic conditions
Broadly speaking, capitalization rates range from 17% at the low risk end of the spectrum to over 30% at the high end of the spectrum.
By working with management, Stevenson Valuation Group has, over time, assisted management in increasing value by enhancing the quality of the company’s cash flow.