Common Mistakes in Business Valuation

Business valuation is a complex discipline that combines financial analysis, legal considerations, and professional judgment to estimate the worth of a business or business interest. Despite its importance in divorce proceedings, shareholder disputes, and tax matters, persistent errors and mistakes in valuation can lead to flawed conclusions. This article examines some of the most frequent mistakes in business valuation that valuation professionals should avoid to ensure a complete and accurate valuation is completed.

Standard of Value

One of the most prevalent errors in business valuation is the misunderstanding or misuse of the “standard of value.” The standard of value defines the conditions under which a business is appraised and significantly impacts the valuation being performed.

The definitions of the most common business valuation standards are as follows:

Fair market value – A standard of value considered to represent the price, expressed in terms of cash equivalents, at which property would change hands between a hypothetical willing and able buyer and a hypothetical willing and able seller, each acting at arms-length in an open and unrestricted market, when neither is under compulsion to buy or to sell and when both have reasonable knowledge of relevant facts.

Fair value (under state statutes) – A statutory standard of value that varies by jurisdiction and generally revolves around the applicability of valuation discounts.

Fair value (financial reporting) – A standard of value used in financial reporting, in which the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

Investment value – A standard of value considered to represent the value of an asset or business to a particular owner or prospective owner for individual investment or operational objectives.

Errors tend to occur when valuation professionals apply the wrong standard of value,  such as using fair market value when fair value is required by statute or court order. This can lead to miscalculations, inappropriate application of valuation discounts, and ultimately, potentially incorrect and undefendable valuation conclusions.

In most instances, the selected standard of value will impact whether valuation discounts should be considered.

• Under fair market value, valuation discounts are typically considered if valuing a minority or nonmarketable interest, because the hypothetical buyer would factor in these limitations.
• Under fair value, courts may explicitly prohibit one or both discounts to protect minority shareholders.
• Under investment value, discounts may not be relevant, especially if the interest is being valued to a buyer who will obtain control or liquidity through acquisition.

Furthermore, parties may incorrectly assume that all valuations are interchangeable (e.g., an estate and gift valuation under the fair market value standard being utilized in a litigation with a jurisdiction with a fair value standard), disregarding the legal context determining which standard is appropriate. It is important to understand the standard of value applicable in the jurisdiction where the valuation is being performed.

To avoid these errors, it is crucial for professionals and their clients to have a clear understanding of the applicable standard of value and to communicate it explicitly in any valuation engagement.

Valuation Date

The understanding and proper selection of the valuation date is a crucial component of business valuation. The valuation date is the specific point in time at which the business or business interest is appraised, and it can drastically affect the valuation conclusion due to changes in economic conditions, business performance, or market events occurring between various dates. Many assume that the most recent date, often the current date or the date of trial, is always the appropriate reference point. However, in many legal contexts, such as divorce or shareholder disputes, statutes or court orders may mandate the use of a different valuation date, such as the date of separation, filing, or another event that precedes litigation.

Using the wrong valuation date can result in a business value that does not accurately reflect the parties’ interests at the relevant time, potentially benefiting one party unfairly or leading to contested outcomes. For example, a valuation date of November 30, 2019, could provide a drastically different valuation than that of March 1, 2020, due to economic factors related to COVID-19

In addition, business valuations are performed under the assumption of what is “known or knowable” at the valuation date. If a business subsequently experienced significant growth or decline after the appropriate valuation date, considering those changes in a valuation analysis would be inappropriate.

Therefore, clarity on the valuation date and subsequent events is essential, and both legal and valuation professionals must ensure it is clearly defined in every engagement to avoid disputes, confusion, and incorrect results.

Market Approach

The market approach is based on the principle of substitution. In the market approach, value is derived by comparison with prices paid for investments with similar risk. For business valuation, the market approach relies on a comparison of a subject interest to investments in companies (guideline companies) that are similar to the subject company, whose shares are either publicly traded or have been acquired in the merger and acquisition market.

While the market approach is conceptually sound, a common mistake is assuming companies within the same industry are automatically comparable. For example, consider applying the market approach to value a family-owned pizza parlor. Would it be appropriate to apply pricing multiples derived from a public company such as Domino’s (Ticker: DPZ)? The answer is no, and the reasons as to why is because public companies:

• Are typically much larger in size in terms of revenue and asset base,
• Are more diverse geographically,
• Benefit from economies of scale,
• Benefit from national brand recognition,
• Benefit from professional management, strict reporting requirements, and oversight,
• Benefit from low(er) cost access to capital.

These factors justify higher valuation multiples. The resulting value would be overstated and misleading if a valuation expert applied those same multiples to the smaller family-owned establishment without appropriate adjustments. 

The same applies when deriving pricing multiples from companies transacted in the mergers and acquisitions (M&A) market. M&A multiples often reflect unique deal-specific circumstances that may not apply to the subject company. For example, a buyer may have paid a premium when acquiring a company due to synergies. The valuation expert must ensure the subject company is truly comparable to the underlying transaction, or else any resulting value may be misleading.

Inconsistencies within Methods

Another frequent mistake in business valuation is internal inconsistencies between methods. It is standard practice to consider all three approaches: the asset approach, the income approach, and the market approach. However, the valuation expert must ensure that the assumptions applied in each method are consistent.

For example, a valuation expert may reject public company multiples in the market approach (for the above reasons). Yet, in the same report, the expert may use those same public companies in the income approach to develop the beta utilized in the Capital Asset Pricing Model (CAPM). In this case, the expert may be saying public companies are comparable for risk, but not for value.

Courts and opposing counsel often highlight these internal inconsistencies to challenge the reliability of an expert’s opinion. Therefore, it is essential that valuation professionals maintain consistency across approaches.

Failure to Reconcile Value Conclusions

Even when each of the three primary approaches — the asset approach, the income approach, and the market approach — is applied correctly, another common mistake is failing to reconcile the results derived from each approach. Rarely do these methods yield identical results, and the differences must be explained, weighed, and reconciled.

Some valuation professionals present three separate conclusions and average them, but without providing justification for the assigned weighting. Others implicitly give one method full weight while including the others only “for reference”. The expert must articulate why certain methods are more relevant than others in the specific circumstances of the case, such as emphasizing the income approach for an operating company with consistent cash flows, while discounting the use of the asset approach because the company being valued is not asset-intensive and liquidation is not a realistic option.

A well-supported reconciliation demonstrates that the expert has considered all available evidence and exercised professional judgment in arriving at a credible conclusion of value.

Conclusion

In summary, business valuation requires careful attention to applicable valuation standards and expertise to ensure accurate and defensible results. By understanding and correctly applying the appropriate standard of value, selecting the relevant valuation date, and properly applying the valuation approaches, professionals can avoid the most common mistakes that lead to flawed conclusions and disputes. Valuation professionals should clearly communicate these foundational concepts, maintain consistency throughout their analyses, and avoid common mistakes. Doing so not only enhances the quality of the valuation but also promotes fairness and transparency for all parties involved in the process.

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