Common Errors in Business valuations

Written by: Megan Hoss, CPA

Business valuations are required for a variety of purposes, ranging from succession planning to marital dissolution. Despite the abundance of guidance available, business valuations often contain errors and inconsistencies that render the conclusions meaningless, or worse, misleading.

Whether it’s an error in the valuation of Snapchat or an error in the valuation of a mom-and-pop shop up for sale, a mistake in valuing a business can be costly – to both the owners and the valuation professionals. Ultimately, reducing the likelihood of errors in valuations starts with understanding the business being valued and for what purpose, and continues with attention to detail throughout the entire valuation process. Below are five errors that are commonly made in business valuations.

1. Failure to Properly Consider Normalizing Adjustments

Regardless of the purpose, valuing a company is a complicated process with many gray areas. A popular misconception is that business value can be derived by simply reviewing a company’s financial statements.

Normalizing adjustments are made to a company’s historical income statements for non-recurring, extraordinary, or discretionary items in order to reflect the true underlying economics of the business in the hands of the buyer (hypothetical or identified). Common normalization adjustments include:

·         Owner/officer compensation (over or under market compensation)

·         Personal/discretionary expenses

·         Related-party transactions at amounts other than fair market value

·         Non-operating income or expenses

·         Non-recurring income or expenses

Adjustments for ownership characteristics are typically made to reflect changes that a controlling interest holder could make to the cost structure of a business. Typically, this would include, but not be limited to, adjustments to compensation and rent. Determining normalizing adjustments applicable to the company and interest being valued requires professional judgment. Failure to properly consider and apply normalizing adjustments can lead to either overvaluation or undervaluation.

2. Unrealistic Projections

Oftentimes, company forecasts have an upward bias and there is a natural tendency to overstate growth prospects. There are obviously some concerns with this – imperfect judgment can lead to imperfect value conclusions. While it is certainly possible for the company to follow a high-growth trajectory, it should require some inquiry and examination. Some basic questions that should be asked include:

·         What is driving the growth?

·         Is it based on increasing market demand or the taking of market share?

·         What is the company’s strategy to achieve this growth?

·         Is the growth in line with the industry?

·         How sustainable is it?

It is extremely important to examine what is driving the growth and to understand if the growth is realistic and sustainable. Perhaps the company’s facilities are at capacity, or the staff is already overworked and management is spread thin. The issue of bias should always be considered.

3. No Consideration of Net Working Capital Requirements

Ignoring required net working capital balances can result in an overvaluation or undervaluation depending on the specifics of the company being valued and its net working capital balance as of the valuation date. Accountants or business owners usually think of net working capital as simply current assets minus current liabilities. For valuation purposes, net working capital is typically calculated on a cash-free, debt-free basis (and also excludes current non-operating assets and liabilities).

Common issues seen in practice related to net working capital include:

·         Net working capital requirements are not considered at all

·         Net working capital requirements are not based on historical company levels or of those of comparable companies

·         Excess (or deficient) net working capital balance as of the valuation date is not considered

Based on our experience, some best practices to consider include:

·         Calculate and consider the historical net working capital levels of the company being valued and of guideline companies (typically measured as a percentage of revenue)

·         Set a required or target net working capital balance as of the valuation date from which excess (or deficient) net working capital can be measured

As with many valuation topics, there is no cookie-cutter answer for how to deal with working capital. The important thing to remember is that net working capital balances must be analyzed in any valuation.

4. Reliance on Rules of Thumb

In determining the value of a privately held business, business owners and buyers often rely on rules of thumb. However, it is important to remember that most businesses are unique, and applying a rule of thumb without additional analyses can be dangerous.

The fact is, using a rule of thumb fails to address the important value drivers of a specific company. They can be considered too broad to apply to a specific business. Businesses can have very different tax rates, capital expenditure needs, and working capital needs, just to name a few. As no two businesses are the same, rules of thumb do not account for the unique characteristics of a particular company in terms of risks, business model, prospects, growth, etc. which need to be considered for making sound financial decisions. Consequently, if a business is not exactly the same as the industry average (in terms of risk, performance measures, etc.), relying solely on a rule of thumb will certainly lead to an inaccurate value estimate.

Additionally, rules of thumb do not generally reflect changes in the economy or subject interest over time. Oftentimes, as appraisers, we rely on rules of thumb as a sanity check when testing our conclusion of value to see if our final multiples are within the typical range.

5. Failing to Look at What the Future Holds for the Business

Business valuations that don’t consider the outlook of the business and stick to merely capitalizing the average of the last three years of cash flow can miss the current opportunities for the business and other important elements of what drives value for the business. Business valuation is really about the future of the business, not its past. In a business valuation assignment, we certainly look to past results for some perspective, but we do so in order to understand what they might tell us about the future.

 Business valuation is as much of an art as it is a science. A reliable value conclusion requires a thorough and objective analysis of the company itself and the industry in which it operates; supported by appropriate valuation methodologies that are applied in a proper and internally consistent manner. At Cogence Group, we follow generally accepted standards and deliver a supportable and unbiased valuation. Count on the experience you can trust.