Article Review on "Risk and Firm Value a Case of Listed Firms"

Article Review 5 pages (1582 words) Sources: 1+

[EXCERPT] . . . .

Risk and Firm Valuation

Private Firm Risk and Firm Valuation

It takes a lot of effort to establish and build a competitive firm in the corporate world. It does not matter whether the organization is private or public; whether it is profit or non-profit making association. Valuation and risk of a business is a factor that has considerably been explored and various models developed to manage the process. Risk in business valuation is the unpredictability of profits from an investment (Nekrasov & Pervin, 2009). This is to mean the uncertainty to both amount of cash flow and the timing of the receipt of that cash flow. This uncertainty is measured using the standard deviation of the previous returns, examining the average distribution of the cash flow. The bigger the dispersion, the more the uncertainty of the organizations returns size. Uncertainty is a reality in the world while risk lives in the investors' minds.

The Valuation Process

After building an organization or a firm to success heights, there may come a time when the organization may be sold. It is at this time when the question of "how much is it worth" arises. There is no investor that wishes to give up their firm at a throw away price. For the longest time possible, it has posed a formidable challenge to establish a standard means of calculating the value of an organization. Therefore, investors and other interested parties have come together to establish a valuation process. Valuation of a firm is the process that determines the worth of a business (Lehavy & Richard, 2008). The valuation process helps the individual to determine the value to place for the business, depending on if he or she desires to conduct an acquisition transaction, corporate restructuring, merger transaction, sales of securities, and other taxable events.

Similar techniques are used for valuation of both the private and public firms and enterprises. However, finding the actual value of a private enterprise is a hard task (Lehavy & Richard, 2008). It contains more calculations and assumptions that are based on the wide industry and firm statistics. It includes many processes, such as explorative planning, adjusting financial statements and applying the suitable business methodology of valuation. There are many factors that affect the valuation process of enterprises. Such include the size of the firm, management and operations control, lack of operational history, difficulties in quantifying returns, the capital structure and the risk in the business.

The numerous accepted valuation methods yield different results based on the inclination of inputs. Moreover, there are modifications made for the private status of the private firm. Unlike the public organizations, private companies do not have access to capital from equity markets (Chandra & Ro, 2008). Hence, the valuator has to determine the category of the enterprise involved, whether it is publicly or privately traded, and the fitting industry.

The techniques of evaluating the private companies are quite varied. A private enterprise may be owned by a non-governmental organization, or by less than 300 shareholders so as not to be necessitated to report with the Securities and Exchange Commission (Nekrasov & Pervin, 2009). The owners hence keep ownership and the related transactions discreet. The valuation processes of such privately run organizations can thereof be expensive and challenging due to lack of precise financial information. In private enterprises, some non-traditional techniques of valuation are most appropriate. Such include analysis of the invested capital, asset appraisal, replacement costs and capitalization of earnings.

As stated earlier, there are several valuation methodologies used across all categories of companies. However, the most commonly used techniques are the Comparable Company Trading Multiple Analysis, the Discounted Cash Flow Analysis and the Precedent Transaction Analysis, (also called transaction Comps and deal Comps) (Darrough & Ye, 2007). Other methods are Break-Up Analysis, Analysis of Invested Capital/Replacement Costs, Asset Valuation and Leveraged Buyout Analysis.

All these methodologies are influenced by certain factors. These include the lack of market liquidity discounts means that there is always no benchmarking point (Nekrasov & Pervin, 2009). This poses challenge since every evaluation process is new and unique. Setting the discounted value is related to other external factors that affect the whole process. The size of the private firms contributes to the discount of valuation. Moreover, smaller organizations do not attract large buyers. The operating history helps determine the revenue and returns growth; therefore setting the value of the enterprise. The business mix is if the organization is involved in various products or specializes on one product. This helps determine the discount of valuation. The most critical factor is the risk factor.

The factors of valuation, therefore, depending on the methodology used, have a risk associated. The risk of valuation is categorized into a financial risk, liquidity risk and business risk (Anna, Nishikawa & Melissa, 2009). Any entry that influences sales costs, administrative and operational expenses are regarded as a constituent of business risk. Furthermore, business risk is specific for every company, whether private or public. Therefore, to evaluate the risk for a private company, the valuator must have sufficient understanding of the company in subject. He or she ought to determine the economic factors associated to the competition in the field, the industry, the department of management and adequate capital. This way, they can make informed valuation cost of the firm.

Investing is a susceptible activity that requires boldness to venture. All investors take a risk with their finances. This is the financial risk associated with each company. It is specific for every private company (Anna, Nishikawa & Melissa, 2009). The financial risk is related to the interest expenses and pre-income tax returns. The risk is reviewed with reference to the companies financing. Therefore, to do a thorough and effective valuation, the financial risk must be considered fully.

Liquidity risk is not specific to the company. The liquidity risk is related to the uncertainty of disposing a closely-held enterprise at a fair market price. It also puts into consideration the time disposition associated with the money value. It is prevalent to all investors when they decide to liquidate their organization.

Therefore, the private company valuation, much as it has various ways conducting the process not all are appropriate. The techniques of break-up analysis, discount cash flow and asset valuation are not particularly feasible because they require precise information (Darrough & Ye, 2007). Moreover, due to increased business risks and lack of liquidity, these methodologies that need additional research are not effective enough. Therefore, the best valuation procedure for a private company is to use comparable public company with known values. This helps the valuator to access the private company based on the information of the related public company and assuming that the factors apply across the industry market.

In building a legal case for the private enterprise valuation, the legal attorney of the firm or individual should execute a cross examination of the companies pros and corns and hence determine the credibility of the valuation results (Bernier & Ridha, 2010). The cumulative risk premiums for a private business are typically low or moderate. Since the risk level is included in the capitalization computation, it has an ultimate influence on the value of the subject company. Moreover, it is vital to interpret the risk factor contained in each valuation model comprehensively.

From this review, there are clear gaps indicated from the taxation evaluation process. These risks are associated with the equity view of the valuator and models of valuating. Moreover, the fact that market and the prices and values of various factors of production keeps on changing almost every day, more gaps are created in the models hence the need to study how these changes are affecting the process (Lehavy & Richard, 2008). Additionally, the laws and regulations of the corporate sector are diverse and keep on evolving.… READ MORE

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