Building blocks of credit valuation
The reason for this difference in business value is because of the difference in the risk involved in maintaining the cash flow (or profits) of the respective businesses. When calculating their respective values you would use a lower multiple (or capitalisation rate) of profit for the mobile phone shop than for the news agency. The buyer of the news agency
believes he is more likely to maintain profits and for a longer period than if he had bought the phone shop, and is, therefore, prepared to pay a larger capital sum for the news agency.
This brings us to key building blocks in approaching private business valuations, which are:
a) the higher the risk, the lower the multiple, and the lower the price;
b) the lower the risk, the higher the multiple and the higher the price.
(Note: The multiple used to calculate value can also be viewed as indicating the probability (or risk) of future profit growth in the subject company. Should the probability of growth be strong, a higher multiple of current profits will be used. This is similar, but not identical to the approach used in risk/return analysis discussed above.)