Go beyond beta
Industry risk isn’t something you factor in once and then forget about. The pros consider industry risk throughout the valuation process — and its relevance even extends beyond the income approach. Valuation professionals typically factor industry risk into the cost of capital, using a “beta” or other industry-specific risk premium. Here are some questions your expert considers when evaluating industry risk.
What’s the correct industry?
“Industry” is typically defined as a group of people or companies engaged in a particular kind of commercial enterprise. Retail, manufacturing, hospitality or agriculture are examples of how industries are broadly defined, and then they’re subdivided into more discrete categories, such as full-service restaurants, fast food establishments, and pizzerias.
The first step when considering industry risks is to identify the products and services the subject company produces. Then the expert defines the industry (or industries) the business operates in. A complete list of industry codes for North America can be found by visiting the North American Industry Classification System codes and titles at www.naics.com.
When benchmarking performance or selecting comparable transactions to use under the market approach, defining a company’s industry can be critical. In addition, this information can be helpful when forecasting future cash flow, including, for example, any adjustments for accounting methods that differ from industry norms.
Keep in mind, though, that some businesses are generalists while others serve a narrow market niche, and direct comparisons between two similar professional services providers may not be meaningful. For instance, if you’re valuing a management consulting firm, it might provide a full menu of financial services, such as tax, audit, financial advising and employee benefits consulting. Alternatively, it might be a boutique firm that specializes solely in preparing tax returns.
What’s the state of the industry?
Like products, industries go through a life cycle: start-up, growth, maturity and decline. In order to see where a company’s industry falls along this continuum, experts evaluate historic performance.
Pinpointing the industry’s life cycle phase helps gauge where the company is headed and helps identify potential threats and opportunities. It can even impact the company’s future capital structure. For instance, an industry in the growth phase faces rising demand for products and services, which may cause a subject company that participates in the industry to take on debt to fund growth. Conversely, a mature industry might mean that the subject company is a “cash cow” that can afford to pay down debt, thereby increasing the percentage of equity in its capital structure.
It won’t suffice to have a surface-level understanding of how the industry works. Valuation experts who make broad-sweeping conclusions based on generic market trends are likely to under- or over-value the business. For example, companies that operate in a declining market can still grow. In fact, some even gain market share as competitors go out of business.
Are there any new competitors on the horizon? It’s important to research companies that sell similar products and services. Often valuators try to understand competitors’ products, pricing, reputation, financial position, channels of distribution, technology, market share and business models. They’re then able to assess how the subject company measures up in terms of its strengths and weaknesses.
From there, valuators assess how the business competes within its industry. For manufacturers and contractors, delivery, quality and reliability might be the most relevant criteria, compared to price being vital for retail sales or commodity. Alternatively, emerging competitors might steal market share due to cheaper prices, technological advantages or more efficient distribution models.
Valuators also look up and down the supply chain to gauge the relative power of suppliers and customers. Businesses with few partners may possess concentration risks. If a major supplier or customer discontinues its relationship with the subject company or merges with another company, it could interrupt normal business operations significantly.
It’s a team effort
Accurate valuations hinge on taking the time to thoroughly understand the subject industry and where the subject company fits within that group. By working with clients and attorneys, valuation experts can select the correct industry and assess how industry risk affects value. A declining industry could also impair a company’s value, and conversely, an industry with a bright outlook could well enhance the value of a subject company.