Got value?

Expressed in the most simple terms, the value of a business is driven by two fundamental factors:

The amount of cash flow the business is expected to generate for its owners in the predictable future and beyond, and the level of certainty (probability) that the business will, in fact, generate the expected cash flows. Because the future, by definition, is not certain, the expected cash flows likewise are not certain and may be materially different from what was expected. Furthermore, because equity holders are the residual beneficiaries of the business, they hold the highest risk. They have a claim to what remains of cash flows only after every other stakeholder is paid, such as employees (wages), resource suppliers (rent, raw materials), debt holders (interest), and the government (taxes). The owners shoulder any variability in the amount and timing of future cash flows, which includes losses from bad operating years but also high profits from good years.

To determine the value that a business has to its owners, therefore, it is important to form an opinion on the expected residual cash flows that will accrue and that can safely be withdrawn by them without impairing the business’s ability to generate the next periods’ expected cash flows (however short or long these periods are defined to be). The level of cash flows generated in the past has bearing only to the extent that it assists in forming expectations about what will occur in the future.

To put it in the fine language of “accountanese”, cash flow generated by a firm is typically defined as:

Revenues less expenses less taxes less required investments in capital. Required investments in capital reflect the investments needed in working capital (current assets, such as trade receivables and prepaid expenses, less current liabilities, such as trade payables and accrued salaries) and investments in equipment, machinery, buildings, and any other operating fixed assets that are necessary for generating operating income. Of course, the degree of capital requirements for a business is influenced by a variety of factors, including the particular industry, the overall product/service mix that the individual company offers, and the business model and market strategy it follows. For business valuation purposes, interest expenses are excluded from the calculation of cash flows to the firm. Instead, the cost of debt financing is taken into consideration when estimating the risk and uncertainty of the cash flows.

Any business college student knows that in order to increase cash flows (bottom line), you should grow revenues, reduce expenses, or do both. But these activities are not without cost. Often, in order to increase revenues, a company may begin extending credit to customers, which in turn may increase collection risk and push cash flows further in time. Through this tactic, although the firm is able to generate higher revenues, the impact on value, on a risk-adjusted basis, may be less. The pursuit of a higher revenue base and lower expenses is a balancing act, one that essentially may define the success or failure of a business.  

This brings us to the next determinant of business value. Evaluating and quantifying the riskiness and uncertainty of cash flows.

Investing in a business is an intrinsically risky activity. Proper understanding, identification, evaluation, and management of risk are key to the process of creating and enhancing value. Broadly speaking, a business faces two primary risks: (1) business risk and (2) financial risk. Both of these elements of risk affect the uncertainty and range of fluctuations of the cash flows to owners.

Business risk is inherently related to the risk that comes from sales, which itself has various dimensions: demand elasticity of the product or service being sold, competition landscape, and overall consumer preferences. Additionally, business risk is affected by operating risk, which itself is determined by the company’s operating structure. The higher the portion of fixed operating costs compared to variable operating costs, the greater the risk and variability of operating cash flows. 

The other major determinant of risk––financial risk––relates to the use of financing: debt, equity, or a variation of both. Similar to operating risk, the greater use of fixed financing sources of capital (i.e., debt), the greater the variability and uncertainty of the residual cash flows to the owners. A higher portion of fixed costs in the company has a leveraging effect on the rate of returns to the residual owners. That is, operating and financing leverage widens the range of expected rates of return, both on the downside but also on the upside (that is, it magnifies both the positive and the negative results). 

In the business valuation world, what was described above is also recognized as the Income Approach to valuation.

In other words, the value of the business is based on the economic benefits an owner would expect to generate through ownership of an interest in the business, taking into consideration an appropriate fair rate of return. In addition to the Income Approach, there are also two other commonly used, generally accepted valuation approaches: the Market Approach and the Cost Approach.

The Market Approach relies on the premise that value for an asset or investment can be estimated based on actual transactions of similar assets or investments that trade in an open, transparent market. Because Kosovo and Albania do not have public exchanges whereby company shares list and trade frequently, the ability to use this approach is limited. However, prices paid for similar companies, if available, can be used to derive value. For instance, let’s say that the bakery two blocks away from yours was recently sold to another owner. You find out that the bakery was sold for 2x (two times) revenues of the last full financial year. You immediately take out your calculator, and push in the number two, the multiplication sign, and the last year’s revenues of your bakery. The mathematical result would be, as a matter of fact, an indication of preliminary value. However, before you put down the calculator, you remember that some major differences exist between the bakery that was sold and your bakery, and those differences should have an impact on value (call that being a smart baker!). Some of these differences may include neighborhood location, targeted customers, types of baked goods, reputation, business history, and so on. These factors, and many others, need to carefully be evaluated by a valuation specialist to arrive at an objective and meaningful value under the Market Approach.

Lastly, the Cost Approach, which is grounded on the concept that rational individuals would pay no more for an asset or good than it would cost to make from scratch. This approach is generally used for very asset-intensive companies or those that lack any value beyond the realized value of their tangible assets. Additionally, the Cost Approach is applied in the valuation of banks and other financial services companies.

As emerging economies, Kosovo and Albania do not have developed equity markets where business interests change hands freely between knowledgeable, informed investors.

The market for businesses is perceived as highly illiquid in both countries, with heavy informational and financial costs to buy and sell. As a result, cash flow expectations are affected to a large degree by the costs of financing (or financial risks). For stakeholders, this also means that they do not have a reliable feedback mechanism that would otherwise be available if a liquid securities market were in place.

However, meaningful insights on how business decisions and actions impact the value of the company can be extracted by conducting a disciplined and thorough analysis of value-drivers, namely risk and return. These insights can then be used by current management, owners, and other outside parties who have a stake in the well-being of the firm to base decisions. The knowledge gained through a detailed and methodically sound valuation analysis can, and should, position firms operating in Kosovo and Albania to take advantage of the enormous opportunities that are available today for building and increasing wealth. To close with another old Albanian saying––“Knowing is Having”.