The negative effect of the economic downturn on public companies has been publicized throughout the media. This is nothing new since we have been through stock market crashes, credit crises, and recessions throughout history. But what happens to the value of closely held businesses (non-public companies) during these volatile economic times?
There are three primary approaches for valuing a closely held business: the market approach, the income approach, and the asset approach. Economic conditions influence each of these valuation approaches.
Market approach
The market approach calculates the value of an ownership interest in the subject company by comparing it to ownership interests in similar businesses (guideline companies) that have been recently sold. Guideline companies can be publicly traded or privately held. During the early part of most economic downturns, price to earnings multiples of publicly traded companies decline significantly, even before the decline hits the latest 12-month earnings. Therefore, investors pay less per dollar of earnings. As the economy begins to recover, the price to earnings multiples increase; however, the latest 12-month earnings reflect the effect of the recessionary phase. Therefore, investors pay more per dollar of earnings. The problem with using public company multiples to value a closely held business is that the market value approach may understate or overstate the value, depending on whether or not the economy has begun to recover.
Do closely held businesses react the same as public companies? Research indicates that average price to earnings multiples do not fluctuate as much for closely held businesses. However, this does not mean that they are recession-proof. The negative economic repercussions will most likely be reflected in the company’s earnings stream based on a decline in sales, a drop in profit margins, and any increase in expenses. Factors within the local economy most likely have a greater influence on closely held businesses, whereas factors within the broad economy have a greater impact on publicly traded companies.
Another factor that has a negative effect on business values is that merger and acquisition activity generally declines during recessionary periods. A larger discount for lack of marketability may be appropriate due to the illiquidity caused by fewer transactions in the marketplace.
Income approach
The income approach calculates the value of an ownership interest based on the earnings of the company by evaluating the present worth of the future economic benefits that accrue to the investors. These benefits are discounted to present value at a rate of return that is commensurate with the company’s risk. Simply put:
Earnings ÷ Rate of return = Business value
The numerator (earnings) is affected by an economic downturn since projected earnings for most businesses are negatively affected during a recession. The denominator (rate of return) is also affected since an investor may require a higher rate of return based on higher levels of perceived risk. These two factors mathematically produce a lower business value.
Asset approach
The asset approach arrives at an estimate of value by estimating the market value of the individual assets and liabilities of the business. During an economic downturn, a company’s asset values may be down (cash, accounts receivable, inventory, fixed assets, etc.), liabilities may be higher if the business incurs more debt, and equity may be lower based on decreased retained earnings. A combination of these factors results in a lower business value under the asset approach.
Summary
The effect of a volatile economy on the value of a closely held business depends on many factors. Different companies across different industries will be affected in a variety of ways. A business owner can lessen the negative effects of a recessionary downturn by being proactive in implementing cost-cutting measures to maintain a level of profitability when sales levels decline.
On a positive note, there is an opportunity to transfer a greater amount of wealth during periods of declining business values. If you are contemplating a sale and/or gift of your closely held business interest to a family member or key employee, now may be a favorable time. Contact us if we can be of assistance.
Donna J. Schultz, CFP®, AVA, is a manager and valuation analyst. A leader of our valuation team, Donna has many years of business valuation experience for purposes of transition planning, buy-sell agreements, and management planning in a wide variety of industries.