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Identify Your Risk and Value Drivers and Enhance the Value of your Business
By Guest Author Chris M. Mellen, ASA, MCBA, CVA, CM&AA, President, Delphi Valuation Advisors, Inc. | firstname.lastname@example.org
Many people see valuation as primarily a financial calculation, but that is just a fraction of the process. A company’s financial statements portray the results of its financial performance in the past, not the causes and the company’s expected future performance. A company’s success is generally dependent on its ability to produce products or services efficiently, in appropriate quantity and quality, on time at a reasonable cost, and market, sell, and distribute them effectively at a sufficiently attractive price. This success is impacted by the company’s strengths, weaknesses, opportunities, and threats (SWOT) that must be assessed as part of the valuation process. Therefore, a solid qualitative assessment of the company is at least as important as a quantitative assessment when determining value. It is the qualitative assessment where management can begin to identify risk drivers that cause uncertainty for the company, and look for value drivers and opportunities to create value.
An important part of the qualitative assessment is the identification of risk at the economic, industry, and company-specific level. A proper analysis will reflect the company’s external environment (i.e., its opportunities and threats) and then look at its internal factors (i.e., its strengths and weaknesses) including its historical performance, paying particular attention to the competitive factors—the causes—that created the results portrayed on the company’s financial statements. With this history in perspective, the analysis then looks at anticipated future economic and industry conditions, how those conditions differ from the past, and the company’s ability to compete in this expected environment.
The external analysis examines those factors outside the company that will influence its performance and competitive position, including economic and industry conditions. The internal analysis considers the company’s capabilities, including breadth of products and services, production capacity and efficiency, marketing, sales and distribution effectiveness, purchasing power, customer concentration, status and ability to protect intellectual property, technological capability, access to capital, and the depth, quality, and availability of management and employees.
The SWOT analysis identifies and assesses how the company operates, how it interacts with and relies on its suppliers and customers, and how it performs relative to its competitors. From this, a determination of how risky the company is relative to its competitors can be made, considering the industry and economic conditions in which it operates. As the competitive analysis progresses, we identify the causes behind the results reflected on the company’s financial statements. That is, we identify why the company performed the way it did given its competitive environment. And because investment is always forward looking, the competitive analysis ultimately is used to assess the company’s anticipated performance. While history provides a track record, value is primarily a function of the future.
The factors that are identified in the SWOT analysis are frequently referred to as value drivers and risk drivers. Risk drivers cause uncertainty for the company. Value drivers reflect the company’s strengths that enable it to both minimize risk and maximize net cash flow returns. Cumulatively, identifying the risk and value drivers establishes the company’s strategic advantages and disadvantages. They are ultimately quantified in the discount rate that reflects the company’s overall level of risk and in the forecast of expected net cash flows.
This article was sourced from Valuation for M&A: Building Value in Private Companies, chapter 3, authored by Chris Mellen and Frank Evans, Wiley 2010.