Every business faces risks, but some companies are riskier
than others. Assessing a company’s risk is an important part
of estimating its value. Risk and value are inversely related.
That is, the higher a company’s risk, the lower its value.
Risk is a function of a company’s external threats and internal
weaknesses, but these forces only tell part of the story. On
the flip side, a business’s strengths and opportunities
minimize risk and, therefore, build value.
When valuators focus exclusively on one side of the story,
their conclusions are likely to be skewed. For example, to
minimize an estate’s tax burden, an appraiser might unduly
emphasize a company’s weaknesses and threats to justify
excessive valuation discounts. Conversely, the IRS’s expert
might downplay these negative elements and, instead, call
attention to the business’s strengths and opportunities.
Framework for Evaluating Risk
Providing a complete, accurate depiction of a company’s future performance requires the valuator
to consider both positive and negative aspects of its operations. A strengths, weaknesses, opportunities and threats (SWOT) analysis provides a four-pronged framework for analyzing risk that links a business’s
internal strengths and weaknesses to the opportunities and threats in its external environment.
This popular tool helps valuators organize their thoughts and provides a holistic risk assessment.
External forces: Opportunities and Threats
Before jumping head first into a company’s financial performance and operations, the valuator
assesses the external environment in which a company operates. Opportunities are favorable
conditions that — if exploited — may enhance shareholder value. Alternatively, threats are barriers
that jeopardize future performance. In many cases, management has little control over these
external factors. (See the sidebar
“Key external forces that affect value.”)
Internal forces: Strengths and Weaknesses
After the valuator understands the company’s external forces, he or she is ready to identify its
internal strengths and weaknesses relative to its competitors’. Strengths are competitive
advantages or core competencies that enhance value. In contrast, weaknesses restrict the
During the business valuation process
, the valuator also addresses whether a company recognizes and
manages its strengths, weaknesses, opportunities and threats.
Are the company’s short- and long-term goals congruent with these factors? Does management
plan to mitigate threats and correct weaknesses? Is the company taking advantage of potential
opportunities and exploiting its strengths? A company’s value can be adversely affected if
management is unaware of these internal and external factors or if management fails to
incorporate them into its strategic plans.
Impact of Information on Value Estimate
Finally, valuators use the information obtained from their analyses to help them:
- Select the appropriate valuation technique
- Forecast future income streams
- Decide on relevant selection criteria and other subjective adjustments under the market approach
- Build discount and capitalization rates when using the income approach
- Quantify valuation discounts, such as discounts for lack of marketability and control
Review and Investigate
In adversarial situations, a valuator’s subjective decisions may come under attack. Attorneys and
clients need to review valuators’ written reports to ensure that all risk factors have received
They also should investigate exactly how these risk factors affect the appraiser’s computations and
assess whether any factors have been double-counted. Above all else, a valuator’s subjective
decisions should be well supported and reasonable.
Key External Forces that Affect Value
- National and local economic conditions
- Social and cultural trends
- Political factors
- Environmental policies
- Government regulations
- IRS rules
GAAP (Generally Accepted Accounting Principles) revisions
- Level of competition
- Substitute products
- Licensing and capital requirements
- Power of customers and suppliers