Are business valuation approaches lagging behind?

Published on 30 Jul, 2018

The finance world has been using the same methods to value businesses for a long time now. While the business world has changed significantly, valuation approaches remain the same. The changes in business environment and dominance of new elements such as technology in businesses necessitate revision in approaches to business valuation.

The most obsolete valuation approach is the discounted cash flow method. It requires the appraiser to forecast business performance. Of course, an appraiser can make a reasonable attempt with the assistance of the company’s management, but the moot question is how much can a management really predict. Forecasting becomes even trickier for early stage businesses working on disruptive ideas.

Forecasting is increasingly becoming difficult amid ever-changing business dynamics. Our valuation techniques have failed to adapt to the rapidly developing environment. However, the biggest flaw lies not in attempting to forecast business performance but in assuming that a business will survive perpetually. Discussions around the timeline of forecasting cash flows and computing continuity value (interchangeably used as terminal value) for the period beyond the explicit forecast period are essentially based on this principle; however, facts present a starkly different picture.

According to a study by Vijay Govindarajan and Anup Srivastava, professors at Dartmouth, chances of surviving for longer than five years after listing were 92% for companies listed before 1970. However, for companies listed between 2000 and 2009, chances of survival for more than five years after listing declined to 63%. (The result of the study are after controlling for the dot-com bust and the Great Recession).

Are we then ignoring the reality in our theoretical valuation world? The rate of corporate mortality will continue to rise as the share of technology in the economy increases. Unlike traditional businesses, technology businesses rise and decline faster. Incumbents are continuously challenged by new tech startups. New consumer technologies continue to disrupt the market, rendering older ones redundant.

This, therefore, indicates that we have been overvaluing businesses, assuming they will never die. In the past when companies survived longer, though not infinitely, the continuity bias would result in a smaller error in valuation. Today, the magnitude of overvaluation is significantly higher.

It is not just the finite life span that poses the challenge of overvaluation; composition of the asset base of companies is another concern. Intangible assets constitute a major chunk of the asset base of new age companies, and will be reduced to zero if the business does not continue. Old-style brick and mortar businesses own large physical assets, which have value of their own, besides the business where they are deployed. For these businesses, some value would be unlocked in the case of liquidation as well. This is a fair argument; however, liquidation value is not as high as continuity value. For new age businesses, which may not command significant value in case of liquidation, inclusion of continuity value in valuation results in significant overvaluation.

Thus, the question: should we then include continuity value at all? And, if the perpetual life principle is not to be factored in, for how long should one forecast cash flows? 

So while it is difficult to arrive at a standard for explicating the forecast period, consensus can be reached on a few key factors that would contribute to the longevity of a business. Successful businesses that survive longer are open to new ideas and adapt to changes quickly. Focusing on near-term profitability as well as long-term survival, they devise strategies that help them sail through difficult times. Businesses that let the old structures die to make room for the new ones, survive longer.

While, the aforementioned statistics about corporate mortality raise a big question on assumption of business continuity, cases like Nokia and Kodak highlight that even the strongest cannot escape the inevitable.


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