596 Making Key Strategic Decisions
complete valuation is more than simply analyzing the historic financial state-
ments of the business and then making future projections. Valuations that give
the most accurate results consider qualitative matters such as technology
changes, the company’s competition, and its customers. In addition, other areas
that are considered are macro-environment issues such as the industry and the
national and local economic factors that affect the particular business. A com-
plete business valuation will consider the following areas:
- Analysis of the company.
- Industry analysis.
- Economic analysis.
- Analysis of the company’s financial statements.
- Application of the appropriate valuation methodologies.
- Application of any appropriate valuation discounts or premiums.
A large part of valuing a business is the assessment of the investment risk
of buying and owning the business. A buyer of the business assumes the risk
that he or she will actually receive the anticipated economic benefits. Of
course, there is no guarantee of actually receiving the projected income. A
fundamental concept in business valuation is the risk-reward relationship in
making any kind of investment. Rational individuals and companies make in-
vestment decisions regularly by comparing the risk of an investment to the
anticipated rewards. For example, a certificate of deposit from a bank that is
guaranteed from default may have a rate of return (interest) of 5%. This in-
vestment has little or no risk. Investments in large public company (large-cap)
stocks have traditionally returned an average of 10% to 12% per year over the
long term. Small public company (small-cap) stocks have average historical
rates of return in the 15% to 20% range over the long term. These three types
of investments illustrate the risk-reward relationship investors have in making
decisions. Buying large-cap stocks instead of a certificate of deposit carries
more risk and, thus, the market rewards the investor with a higher rate of re-
turn. Small-cap stocks over the long term have been more risky than large
company stocks and have rewarded investors even more with higher returns.
Simplistically, the valuation of a closely held business considers the risk of an
investment in the company and compares it to alternative forms of investments.
Victoria further explains that valuation concepts are founded in several
economic principles. The first is the principle of alternatives that states that
each person has alternatives to completing a particular transaction. In the pre-
ceding example, the individual has the alternatives of investing funds in a bank
certificate of deposit, large-cap stocks, or small-cap stocks. Investing in a busi-
ness is yet another alternative. The second economic principle in valuation is
the principle of substitution. This states that the value of something tends to
be determined by the cost of acquiring an equally desirable substitute. For ex-
ample, if a new restaurant offers steak on its menu, it will likely have a price
similar to other restaurants selling steak (all things being equal). The first