Maximizing Business Value: Understanding Expected Returns and Perceived Risk

Maximizing Business Value: Understanding Expected Returns and Perceived Risk

Introduction: The Core Drivers of Business Value

• Return: Refers to the potential profit or cash flow generated by the business. It is a key driver of business value, as higher returns typically increase attractiveness to investors.

• Risk: Represents the uncertainty in achieving expected returns. Higher risk generally leads to lower valuations due to increased investor caution.

Business valuation means figuring out what a business is worth in today's market. Take a look at any stock market - you'll see the prices of countless stocks updating in real-time during trading hours. These stock prices show what companies are worth and reflect both hard business facts as well as the full spectrum of investor emotions - their expectations, biases, hopes, dreams, and fears at that moment.

Market Value in Action: Recent Case Studies

In the summer of 2024, CrowdStrike, a cybersecurity company, faced a major crisis when a faulty software update for its security software caused widespread IT outages. The incident led to a significant drop in CrowdStrike's stock price, which was down by 15% in premarket trading and continued to drop in the following days. This is an example of how a sudden increase in the perceived riskiness of this company's future earnings led to a sharp and immediate drop in its market value. Later in the year, as the perceived risk around CrowdStrike abated, its stock price recovered.

In March 2025, Hewlett Packard Enterprise missed quarterly profit estimates and provided lowered profit guidance, sending its stock price 15% lower. This exemplifies the impact of earnings expectations on company value. As part of the same press release, HPE announced a cost-cutting program intended to bring earnings back up.

Valuing Private Companies: Beyond the Stock Market

If you consider a small, privately-held company where the market value is not nearly as observable, the two main determinants of value remain the same: the expected return and the perceived riskiness of those returns.

Three valuation methods will typically be considered in determining the value of a privately-held company, with earnings multiples being the most common for small to mid-sized businesses:

• Discounted Cash Flow (DCF): This method looks at what your business might earn in the future, then adjusts those future earnings to today's dollars by applying a discount rate (higher rate for riskier businesses). Think of it as answering: "What's tomorrow's money worth today?"

• Earnings Multiples: This straightforward approach multiplies your current earnings by a certain number (the multiple). For small businesses, this often uses EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), which is essentially your operational profit before accounting adjustments.

• Asset-Based Valuation: This method adds up everything your business owns (equipment, inventory, real estate, brand value, etc.) to determine its worth. It's like figuring out what you'd get if you sold all the pieces separately.

In the DCF method, we account for risk through the discount rate - simply put, riskier businesses get higher discount rates, which lowers their value. With earnings multiples, risk shows up differently: a riskier business gets a lower multiple than a safer one, even when both earn the same amount. Asset-based valuation stands apart because it doesn't factor in risk - it assumes the business might not continue operating long-term. This approach works best for struggling or failing companies, but it's also helpful for establishing a minimum value or "floor" for any business.

Strategies for Enhancing Business Value

Using either DCF or earnings multiples for valuation, it's clear that the path to a higher valuation is by increasing earnings and/or reducing risk. Let's look at a few ways you might approach doing both.

Possible Ways to Increase Return

• Improving Operational Efficiency: For example, using AI to save time, streamlining certain operations to remove non-value-additive steps, or offshoring components of labor.

• Expanding Market Share: Increasing market presence, whether through marketing or entering new markets, can lead to higher revenue.

• Developing New Revenue Streams: Diversifying income sources through new product and/or service offerings can stabilize and grow earnings.

Possible Ways to Reduce Risk

In business, risk can be categorized into:

• Market Risk: This is uncertainty caused by broader economic conditions. While you can't control it (so don't lose sleep over it), market risk definitely affects the value of all businesses. For example, in early March 2025, the stock market dipped for several weeks because of trade and tariff concerns, which likely impacted private business valuations too.

• Operational Risk: These are risks within your day-to-day business operations. A common example is the "key person" risk - when your business relies heavily on one individual whose absence would seriously disrupt operations. If this key person gets sick or leaves, your business could suffer significantly.

• Financial Risk: This involves how you manage money in your business. Having too much debt can be dangerous if business slows down and you can't make your interest payments. But interestingly, having zero debt isn't always ideal either - taking on some strategic debt can boost your profitability. The right amount varies depending on your business type and your comfort level with risk.

The Multiplier Effect: How Earnings Can Expand Valuation Multiples

While both expected return and perceived risk obviously affect business value, here's something less obvious: higher earnings can actually improve the multiple used to value your business (known as "multiple expansion"). I found this mind-blowing at first - I thought multiples only changed based on how risky your business seemed. But it makes sense when you consider an investor's perspective. Businesses with higher earnings are usually more diversified across customers, products, and locations. They typically have full executive teams and dedicated professionals handling marketing, sales, finance, and HR. This means if anyone leaves - even the CEO - the business keeps running smoothly, which makes it less risky.

There's another hidden reason why higher earnings often lead to better valuation multiples for small businesses - you become visible to a whole new category of buyers: private equity (PE) firms. These firms specialize in buying businesses, improving both their earnings and risk profile, and then selling them for a higher multiple typically within 5 years. But here's the thing - PE firms have significant costs when analyzing potential acquisitions and conducting due diligence, so they only look at companies above a certain earnings threshold. Below that threshold, it simply isn't worth their effort.

Conclusion: The Path to Maximum Value

To maximize your business value, you need to work on two fronts: boosting earnings while reducing perceived risk. If you're ambitious enough to grow your business to the level that attracts private equity interest, you can tap into the power of multiple expansion when you eventually sell. This dramatic jump in valuation is exactly what PE firms count on for their own business model - but you can use these same principles yourself. By understanding and applying this knowledge, you can unlock your business's full potential and potentially create a truly life-changing exit when you decide to sell.

It’s about taking the right steps now to realize your business’s full potential later.