MLR

How does the economy bias valuations?

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In a perfect world, a business valuation would be a totally objective assessment of a company’s worth.

growing firm

But many factors can influence the outcome, including parties involved and the purpose of the valuation.

That type of bias might be readily identified and understood. What may not be so clear is the influence of the general economy in valuing a company.

Humans tend to assume the current situation will continue, so if the economy is booming, there will often be a sense of urgency that can bump business values upwards. Everyone wants to cash in on rising markets.

The opposite can also happen. During the recent recession, property values plummeted, and there was a pervasive belief that business was bad everywhere, for everyone. Distress sales and foreclosures created a further downward drag, as the pool of comparable transactions shrank in number and sales price.

In actuality, some companies grow during recessions. Conversely, some fail in good times. The following situations can all be true:

  • A company in a growing sector is undercapitalized and undermanaged so it fails
  • Despite challenging industry performance, a business operates prudently, riding out the recession until better times
  • Some industries perform well during recessions
  • Certain industries are unaffected significantly by either recession or growth
  • A business seizes growth opportunities by buying up defunct or failing companies in their sector
  • A product or service is in decline and becoming obsolete
  • The poor economy has affected sales to the point that the business is in distress or bankruptcy

To minimize economy bias, there needs to be a deep understanding of the sector and industry. A good or bad economy can cause micro-bumps or declines in overall performance.

What’s the long-term history and outlook? Some industries have experienced a long, slow death as production has moved overseas. Consider the paper industry, which also affects the associated sectors of trucking and logging. Once the mills closed, truckers and loggers needed to find new markets or go out of business.

Other industries have become more efficient, thereby lowering the cost of items. This can be a double-edged sword. For example, there is burgeoning demand for consumer gadgets but repair and service companies are practically obsolete. It’s just not worth it to fix cheap devices.

Demographics are another factor beyond company or industry control. Analyzing the present and future customer base is critical, whether selling to businesses or consumers. Is it growing or shrinking? Are trends killing the market for the company’s products or services? Is the company seeking and responding to new opportunities?

For certain sectors, suppliers are another area to consider, as well as trends in those industries. If raw materials are sourced in a politically unstable area of the world or are subject to environmental scrutiny, that could be key to future viability of the company. Wholesale price trends and number of suppliers can also influence profitability.

The operating geography also needs to be examined. The scope of that picture will be different depending on whether the company is global or operates in a specific city or neighborhood.

If customers are local and the area is in decline, it could greatly affect value. Conversely, redevelopment plans or large companies coming in might provide opportunity for those who can sit on their investment.

Tourism is an industry that can be volatile in down markets. The long-term visitor trend for an area should be examined to determine if declining sales are likely to reverse when disposable income bounces back.

Once a solid picture of the industry and environment has been developed, analysis of company performance can be reviewed in this context. Peer performance and industry financial ratios can shed light on whether the company is adequately managed considering current challenges and opportunities. This is in addition to the standard financial statement review and assessment of liquidity, liabilities, and equity. Other areas to assess include employee turnover, owner compensation and bank relationships.

Poor management might mean a golden opportunity for the right owner, since possible profits are being eroded. Or the company’s goodwill might be nonexistent, in which case an asset sale could be the way to go.