How does uncertainty impact the value of a small business?
A recent speech by one of the RBA’s deputies (Guy Debelle) provided a complicated sentence that sums up the current issues facing many business owners – the impact of uncertainty on the value of a business.
- “The relative stability of macroeconomic outcomes might be delivering a little more stability in the numerator in investors’ calculation of expected future returns. But it is not clear to me why there should be more stability in the denominator, the discount rate. If anything I would argue the converse, namely there is at least as much uncertainty about the future path of interest rates as in earlier periods.” – Guy Debelle (Business Insider)
Now many may have a bewildered look on their face and quietly mouth the phrase “WTF?”.
To be honest, he was referring to the yield and capitalisation rate on bonds – but the same theory applies to the cash flows from any business – even small business.
In simple terms, the value of any financial asset (including a small business) is the future cash flow generated by the business (the numerator in Debelle’s equation) divided by the cost of capital (the denominator).
In essence he is suggesting that under current economic conditions, business is experiencing some stability in cash flow (I did say SOME). But the cost of capital used to capitalise those cash flows (to arrive at a value in todays dollars) has at least as much uncertainty as it has in the past (and probably more).
What Debelle is referring to is the uncertainty associated with the movement in interest rates in a number of different markets, and this is impacting other economic factors.
For a small business this really refers to uncertainty in the cost of capital – or the multiple that should be applied to the future earnings of the business. It highlights that there may be some improvement in valuations for some small businesses, but they are variable.
This can be rationalised by thinking of an imaginary $500,000 that you have sitting in the bank. You can do a number of things with this money:
- Leave it in a long term account and get 3-4% pa as a return (before tax).
- Invest in a rental property and get 6 – 10% pa (before tax) – excluding capital growth.
- Purchase blue chip shares and get 4 – 8% dividend yield (before tax) – excluding capital growth.
- Buy gold and hope the price goes up again in future years.
- Buy US dollars and sell when the Australia/US exchange rate has fallen further (possibly in the next 6-12 months).
- Purchase speculative shares and hope you can double your money before it all disappears again.
- Purchase a lot of Tattslotto tickets.
Or you can purchase a business and apply your skills to earn a greater return.
The options listed above each have different risks – and hence the cost of capital will vary.
Why will these options impact the value of a small business?
If there is uncertainty about the cash flow and returns of the business, then the capitalisation rate will increase to reflect the risk (the earnings multiple and hence business value decreases). If someone has a better option for investing their $500k then they are more likely to take the less riskier option. In other words, to attract a buyer the price must be reduced.
How uncertain is the cash flow in your business? How does the risk of your business compare to the broader industry or other investment options?
If you want to discuss your business risk and how it may impact the value of your business then contact us for a complimentary obligation-free phone discussion.