10 Common Mistakes in Business Valuation (and How to Avoid Them)
Business valuations provide vital information to business owners and management teams. They inform transaction prices and the value of shareholders’ equity, both of which can help you select the optimal timeline for exiting the business. With so much riding on these reports, it’s imperative that management teams have conclusions that they can rely on. Keep an eye out for these 10 common mistakes so that your valuation remains a reliable resource for you and your team.
1. Using Flawed Valuation Models
A business valuation’s applicability is heavily dependent on the model your practitioner uses. The three main valuation approaches are (1) the Income Approach; (2) the Market Approach; and, (3) the Asset Approach. There are various methodologies under each approach that may be applicable depending on the company and the nature of the engagement. Your valuation practitioner will select the method that best reflects the economic realities of your business. No matter what method your provider chooses, make sure the model addresses the following:
- Non-operating assets
- Off-balance sheet liabilities
- Level and treatment of risks
- Non-financial consequences of a potential sale
And at the end of the day, always ask yourself if the conclusion seems reasonable.
2. Using Flawed Projections
To reach valuation conclusions, judgment is required, which means that imperfect judgment can have heavy consequences. This is especially true when projecting those assumptions years into the future. To mitigate mistakes that arise from imperfect assumptions, make sure your valuation provider uses market-based forecasts when possible. Any business growth that your valuation practitioners assume should be supported with evidence. Don’t be afraid to ask where their assumptions came from.
The same should be said about your own projections. Your management team may have strong feelings about where the business is headed, but if those estimates vary wildly from your provider’s, explore the incongruence and find a middle ground. Perhaps one party overlooked capacity constraints, or maybe one party assumed the growth rate would continue in perpetuity (which is very rarely the case). The sooner you can address these flawed assumptions, the sooner you can settle on an asking price and move forward.
3. Overreliance on Rules of Thumb
It can be easy to rely on anecdotal evidence or “rough estimates,” especially if you come from an industry that has a long history of buyouts and mergers. Typically, these estimates are expressed as multiples – “5 times EBITDA” or “1 times revenue.” These estimates are a form of market-based valuations, but with less room for adjustments. Cash flow, growth, location, competition, accumulated debt, operational efficiencies and so many other factors need to be taken into account. By all means, keep those rules of thumb in the back of your mind, but don’t let them outweigh the research you and the valuation team have done.
4. Blindly Using Comparable Transactions
A well-practiced valuation provider may have been involved in similar private company transactions that can help inform your business’s appraisal. Unfortunately, businesses get into trouble when they rely too much on comparable transactions. At a minimum, your valuation professional should perform additional analyses to show how your business compares to the comp. Comparable transactions are best used as starting points or benchmarks, not as final conclusions of value.
5. Mismatching Control Adjustments with the Interests Being Valued
When a new controlling owner takes over the business, it stands to reason that the economies and efficiencies of the business will change. These changes should be taken into account.
But first, know what interests you are valuing. A minority interest valuation will look quite different than a controlling interest valuation. A minority shareholder will have less control over compensation decisions, operational adjustments, and the like, so their interest’s value will look different than that of a controlling shareholder.
6. Failing to Investigate Mathematical Errors
Math errors can have a bigger impact than you think. An error that occurred early in the valuation process can upset assumptions that were made later on. It’s worth your time to recalculate the values and reanalyze your discoveries in light of that corrected information. If the valuation expert you’ve chosen makes a few math errors, it may not be the end of the world, but it’s worth exploring to see if they’ve made simple mistakes elsewhere in your report, as well.
7. Using the Wrong Standard of Value
Before you begin, you and your team should specify your “standard of value.” A standard of value is the measure by which your business will be appraised.
- “Fair market value” reports the would-be selling price that an unrelated buyer and seller would agree to.
- “Investment value” is based on a business’s expected earnings, or on the monetary return for a specific investor.
- “Fair value” is a hazier concept of fair market value. Fair value may have different meanings depending on the purpose of the valuation. In litigation matters, fair value may be statutorily defined; however, fair value has a different meaning for financial reporting purposes.
There is no single right selection, but the standard of value you choose will affect your bottom line, so be able to justify your selection.
8. Assuming an Inappropriate Capital Structure
An entity’s capital structure – its combination of equity and debt – heavily affects its cash flow and therefore its valuation. When controlling interests are being valued, most experts will try to determine the company’s optimal capital structure and calculate their valuation based on that ratio. This is logical because when controlling interests change, the new owner has the ability to change the company’s debt-to-equity ratio.
When minority interests are being valued, the opposite should be true, and it’s a mistake that many business valuations make. Non-controlling shareholders have no ability to alter their entity’s capital structure, so the company’s existing ratio should be used in the calculations.
9. Mismatching Discount Rates with Measures of Economic Income
In business valuations, discount rates are used to convert a series of future anticipated cash flows into present-day values. Unfortunately, discount rates created for one income stream can get applied to another inadvertently. You don’t want an after-tax discount rate to be applied to pre-tax income.
Discount rates take multiple factors into account, including:
- The uncertainty of the payments;
- The stability of the industry; and,
- The size of the company.
Discount rates reflect the risk inherent in the cash flows. In general, discount rates applicable to cash flows to equity holders are higher than those applied to cash flows to invested capital, which includes both equity and debt holders. Applying a discount rate to the wrong measure of economic income can result in a material misstatement in the analysis.
10. Mismatching Interest-Bearing Debt with Measures of Economic Income
As discussed above, cash flows to invested capital include economic income available to both equity and debt holders. Failing to properly account for interest and interest-bearing debt when converting an invested capital value to an equity value will result in a value conclusion that is significantly misstated, especially if the company is highly leveraged.
When in Doubt, Seek a Second Opinion
If you notice one or more of these mistakes in your business valuation, consider getting a second opinion. An experienced provider can help alleviate your concerns. Don’t let your flawed business valuation lead to suboptimal decisions.
For more information on what to look for in a quality business valuation, contact us.
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