Business valuation has been conventionally based on the financial and monetary representation of a business element by using financial, economic, accounting evidence, and materials. The process is not directly assessed by the performance of the business practices and companies’ operational aspects. The use of additional information with regard to the business valuation process requires the development of a new process which is able to handle different types of information. Business valuation also needs more data which could be developed from historical and current performance, forecasting, and strategic focuses. This information will be used as a strong point to develop a financial impact where it can be incorporated to determine value in the business valuation process. The main objective in business valuation is to determine a representation of the overall worth of a business entity. The value of a business is from a monetary point of view. There are several factors that business valuation requires such as: merger and acquisition, acquiring a business which needs to determine the price to pay, brand and equity valuation, dividing assets between individuals, and the assets’ value and asset class worth. A precise representation of the overall value of the company is the key to ensuring a good, strategic decision in the business valuation process.
2. Identification of Risk Factors in Business Valuation
Business valuation has many complexities and controversial facets for a business valuation expert, especially a valuer. The valuer must have passion for the subject and be willing to accept all odds in pursuing the objective. The valuer also needs to have in-depth knowledge of accounting, corporate governance implications, financial analysis, industry information, management knowledge, and standards for valuing a business. Property is always linked to the business entity; therefore, the role of valuers in business has been significant in recent years. Business valuation is frequently a confusing subject. Some do not know the purpose of a valuation, such as not realising what the valuations are required for. The valuers need to tackle this problem hands-on if the case is really pursuing the subject matter, which could also mitigate risk in professional liabilities of a business valuation. Moreover, the selection of an appropriate technique is of paramount importance in arriving at the value of a business. The three universal approaches for business valuation are: asset approach, income approach, and market approach; therefore, the question is which approach a valuer shall consider for valuing a business. Valuers are faced with the task of valuing business equity and have to choose an approach, especially if the intrinsic value does not appear in the financial statements. Some elements in business valuation such as intangible value, multiples, or discounted cash flows are easy to use, but they could also be misused. Therefore, relevant facts must be used in order to achieve an accurate value.
Generally in the valuation process, it has long been debated that risk and uncertainty are due to the interchangeability often found in another description.
Lorenz and Lützkendorf (
2011) define risk from the perspective of investment and finance associated with an asset that contains volatility of its returns.
French and Gabrielli (
2004) describe risk as the measurement of a loss identified as a possible outcome of the decision and uncertainty as anything that is not known about the outcome of a venture at the time when the decision is made. While
Adair and Hutchison (
2005) define risk from the context of property investment as the probability that a target rate of return will not be realised and argue that the concept of risk supposes that all outcomes together with their probabilities of occurrence are known.
Adams et al. (
1998) argues that risk is a word that refers to the future where no objective existence with the future is only by imagination. From the definitions, it seems risk is associated with something uncertain. Nevertheless, in business valuation, where money and profit are important, error in risk is crucial where industry players need to minimise the element of uncertainty to determine risk in the business valuation process. Industry players prefer the element of risk and uncertainty to be dealt with.
French and Gabrielli (
2004) propose that the most appropriate measure to manage risk and uncertainty in the valuation process is through a statistical approach.
RICS (
1994) also emphasise that valuers should draw attention to and comment on any issues affecting the uncertainty of the valuation. Furthermore, valuers are responsible to provide explicit risk communication to clients in the form of a quantifiable risk score which depends on the valuation case subject matter. Communication of risk in valuations assumes far more importance in emerging markets where the data on comparable evidence for basing the valuation are sparsely available, and assumptions need to be clearly reported (
Gupta and Tiwari 2014). In addition, risk reporting alongside property valuations assumes greater importance in the background, especially with recent financial crises such as the Global Financial Crisis (GFC). Banking sectors are also getting strict with valuations that were determined by the valuer. The valuations of the cases provided by the valuers are normally based on current market conditions. Nevertheless, the decisions that are made are always exposed to risk from the element of uncertainty. As mentioned in
RICS (
1994), valuation reports must not be misleading or create a false impression. The valuer should draw attention to and comment on any issues affecting uncertainty of the valuation. The extent of that commentary will vary depending on the purpose of the valuation and the format of the report agreed upon with the client.
In general, any profession or employers may be held liable for an accident arising out of the general course of employment. As a professional, it is necessary to take every step possible to try to prevent lawsuits by following professional standards and duty of care; however, we live in a litigious society where just about anyone can sue for negligence. Risk in professional practices such as values also involves professional liability. Professional liability is a legal obligation arising out of a professional’s error, negligent acts, or omissions during the course of a valuation. In the process to determine the value of a property, in most cases, it is carried out very well; nevertheless, in some cases, valuers might provide value incorrectly. Consequently, in order to achieve the most accurate value in the valuation process, valuers have a duty of care to take all measures when surveying or valuing a property. This includes the inspection process which requires full and detailed surveys. As a result, the final valuation result will be a professional opinion of value which could be different from one professional to another. The differences among valuers in determining value, known as margin error, depend on the type of property. This is where evidence will play a major role to prove that valuers did not act in a negligent manner.
The future is unknown; thus, that is where risk and uncertainty exist. According to
Aven (
2016) risk has existed for 2400 years by the Athenians; however, risk assessment and risk management were created around 30 to 40 years ago. There are many definitions of risk. Based on previous studies, risk is defined as undesirable, negative effects, unfortunate occurrences, deviation, or unexpected occurrences from the planning of the activity. There are also many other risk definitions.
Kliem and Ludin (
2019) categorised risk as follows:
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Acceptable vs. non-acceptable risks
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Short-term vs. long-term risks
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Positive vs. negative risks
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Manageable vs. non-manageable risks
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Internal vs. external risks
Usilappan (
2006),
Williams et al. (
1998) defined risk from an investment value perspective, which is different from the targeted returns from investment outcomes, such as when risk has no certainty of the outcome. Furthermore, risk is an objective concept and can be measured.
Khumpaisal (
2011),
Wiegelmann (
2012) defined risk as a possibility of negative or unfavourable impacts from a present process or future event to an asset, project, or some element of value.
Riley et al. (
2006) explained that risk is also known as uncertainty. According to
Manaf et al. (
2006), risk is part of business and public life and is an adverse event based on circumstances. From an investment view, investment objectives cannot be achieved as risk returns uncertainty over time. Risk also arises from unexpected volatility in asset returns over time or the uncertainty of future outcomes. According to the
Institute of Risk Management (
2002), risk is a combination of the probability of an event. Risk is also a consequence that constitutes the upside (benefit) or downside (threat to success) on one or more project objectives, i.e., scope, schedule, cost, and quality.
Sloman and Wride (
2009),
Obinna (
2017) defined risk a result of an action that may or may not occur. Risk as defined by
Kliem and Ludin (
2019) is the occurrence of an event that has been impacted on, and there are five elements of risk, as follows:
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The possibility of the occurrence of risks whether high, medium, or low risks.
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Frequency of occurrence of risks.
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Impact of occurrence of risk.
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Other important related factors associated with risks.
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The exposure of the impact of risk on the product or result of the project.
Riley et al. (
2006) further elaborated on sources of risk which may cause fluctuations, as follows:
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Fluctuations in expected income—varying dividends, missed interest payments, or unoccupied rental of real estate.
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Fluctuations in the expected future price of the asset—changing economic conditions or asset-specific circumstances.
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Fluctuations in the amount available for reinvestment and fluctuations in returns earned from reinvestment—changes in tax rates, interest rates, or asset returns.
Wilkinson and Reed (
2008),
Riley et al. (
2006),
Williams et al. (
1998) classified risk into systematic risk (involves movement in a group over time) and unsystematic risk (deviation of individual security returns from group average). Details of both systematic and unsystematic risk are as follows:
The risk of holding a diversified portfolio is minimum, and systematic risk cannot be reduced by having diversification. The remaining risk is called systematic risk. This risk affects the economic or financial system (pervasive throughout the economy) such as interest rates, economic growth rate, changes in taxes, changes in government policies, fluctuation of exchange rates, and major military actions.
- ii.
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Unsystematic risk
In contrast with systematic risk, unsystematic risk can be reduced by diversification. This risk is also known as asset-specific risk. Unsystematic risk is focusing on a smaller view rather than a broad economic view such as the type of asset or security issuer. The examples of unsystematic risk are poor management decisions, labour strikes, deterioration of product or service quality, and the rise of new competitors.
Muka (
2017) explained that risk is an interaction between threat and hazard of vulnerabilities. When risk is present, outcomes cannot be forecasted with certainty; thus, risk gives rise to uncertainty. As the future is unknown, risk and uncertainty exist. According to
Tesfaye et al. (
2016) risk and uncertainty are two common terms which are closely related with a negative outcome of a certain event. There are many ways of defining the relationship between risk and uncertainty. Risk and uncertainty are two common terms in the risk management literature.
Kliem and Ludin (
2019) explained that risk will reflect uncertainty, while
Williams et al. (
1998) defined that uncertainty arises when we perceive risk and doubt to predict the future.
Sloman and Wride (
2009) explained that uncertainty exists when the possibility of the outcome is unknown. The contrast of uncertainty is certainty. Different to uncertainty, certainty is a subjective concept; thus, it cannot be measured directly; however, certainty can be measured indirectly, such as in science and mathematics.
Risk in Business Valuation
In order to determine the risk levels in business valuations, the main research instrument to investigate risk is through a questionnaire. For the purpose of this objective, the questionnaire is categorised under two different sections, namely, risk in a business valuer’s profession and risk in the business valuation process. Under the section of risk in a business valuer’s profession, the aim is to identify the areas where valuers are able to limit the exposure of professional liabilities among business valuation practitioners. Under this category, respondents are also required to categorise risk, whether it is systematic or unsystematic risk. The explanations of these risk categories were explained in a previous chapter. These questions need the valuer’s professional views based on their experience as valuers, accountants, or institutional investors. The risk areas in business valuation are based on three major risk categories, namely, risk in business valuation, systematic and unsystematic risk, and risk in quality valuation reporting. These risk areas were identified from previous research undertaken by
Trugman (
2016). The risk areas were categorised based on the approach or method used in business valuations. In an asset-based approach, the most likely risk to be encountered is when adjustments to assets typically require adjustments to the income statement in the form of increased expenses or reduced revenues. In the process of determining the value, managers have incentives to deflate reported earnings which occur when a firm is performing very well and encourage them to put some funds away for a rainy day. Furthermore, accounting rules could also lead to the understatement of assets. In several countries, accounting standards require firms to record expense outlays for research and investigation should they encounter future valuations for owners which could lead to uncertain outcomes.
Asset understatement could occur when managers have incentives to understate liabilities. Accountants need to analyse whether managers have a tendency to understate or overstate assets and, if necessary, adjust the balance sheet and income statement accordingly. This will also lead to the ambiguity in determining a fair value. In an income approach, the evaluation of a firm for the purpose of business valuation will involve larger investment processes that include several elements, namely, establishing the objectives of the valuation, forming expectations about the future returns, and combining income into portfolios to maximise progress toward the investment objectives. Furthermore, the foundation is projecting returns and assessing risk to identify mispricing of the case subject matter in the hope of generating returns that more than compensate the investor for risk. For valuers who do not have a comparative advantage in identifying mispricing of the case subject matter, the focus should be on gaining an appreciation for how the income approach would affect the risk of a given portfolio and whether it fits the profile that the portfolio is designed to maintain. Unlike assets which have fundamental existence, income analysis in business valuation is relative. In analysing income, the monetary amount representing the difference between revenues and expenses (or, in other words, revenues minus expenses) equals earnings or income. Therefore, in this approach, a financial statement is vital and is used to investigate the revenues and expenses to understand income. It could also benefit from understanding important items in the income approach, namely, revenues, expenses, and earnings related to underlying assets and liabilities. Another important element in the income approach is income statement adjustments. The normalising adjustment and control adjustment will turn the income statement into a proper application. In normalising adjustment, the earnings of the company need to be reasonably well-run based on an equivalent basis. It can be further divided into two types, namely, typical financial buyers and particular buyers. The majority of valuers do not distinguish between normalising and control adjustment. It is important to distinguish between types of income statement adjustments when determining the discount rate applicable to derived earnings. The discount rate or capitalisation rate applied to a particular measure or earnings must be appropriate to measure net income, pre-tax income, debt-free income, or another level of the income statement (
Mercer and Harms 2020). These are the possible areas which could influence the justification of value in an income approach.