The process of valuing a business involves different types of methodologies and formulae to determine a business’ value. These valuations help business owners make decisions to sell or to continue with their companies. Business valuations serve many purposes, including notional valuations (e.g., income tax reorganizations, related party transactions, and shareholder disputes) and open market acquisitions and divestitures.
Errors and inconsistencies in the business valuation process result in misleading conclusions, making them meaningless. Accurate results play a crucial role, especially when they form the basis of a transaction.
Business Valuation Mistakes to Avoid
With years of business valuation experience, Value Scout knows how mistakes in the valuation process cost business owners and investors. Valuators must watch for the following errors and ensure that their business valuation process and its outcome are error-free, accurate, and reliable.
Omitting Essential Assets and Liabilities in Business Valuation
Business valuation involves accurately valuing the assets and liabilities of a company to arrive at its net asset value. Net asset value is the value of all assets less the value of all liabilities.
Net working capital (NWC) helps measure liquidity, short-term financial health, and operational efficiency. The formula to calculate it is current assets minus current liabilities.
Working capital levels are vital to the business valuation process, especially when using the income approach. Cash flow is the net amount of cash and cash equivalents coming in and out of business. Changes in working capital impact the company’s cash flow and reflect in the cash flow statement.
Non-operating assets are assets that are not a part of a company’s core operations. Analysts usually omit these assets and any income from them from the financial analysis of a company’s core business. When using the asset-based approach to calculate a company’s net asset value, they make adjustments concerning the market value of assets and liabilities.
As businesses apply depreciation to their assets in the balance sheet, their value decreases over time. Thus, the book value of an investment is not necessarily equivalent to its fair market value (the price that an asset would sell for on the open market).
Using the Wrong Valuation Multiples
Valuation multiples include price-to-earnings (P/E) ratio, price/cash flow, price/earnings-to-growth (PEG) ratio, enterprise value-to-sales (EV/sales), EV/EBITDAR/EBITDA/EBIT, etc. Analysts incorporate them into different approaches to arrive at a business value.
Valuation multiples are calculated after analyzing comparable public companies or comparable precedent transactions. For a valuation multiple to be applied to the subject company, the relative data must be similar in size and industry.
Opting for the Wrong Standard of Value
Analysts use different standards of value for business valuation. The most common forms include:
- Fair market value. The price at which a business or asset would sell between willing participants, with equal knowledge of all the facts, exists only in theory. Fair market value is the most common standard of value used in most business valuation assignments.
- Investment value. This is the value that a specific investor hopes to derive from an asset or business. It depends on how a particular investor plans to put the asset or business into use and their ability to derive the highest value from it. The result is generally higher than fair market value or liquidation value as a standard of value.
- Liquidation value. If a company is going to be liquidated, this is the value of its tangible assets. Since liquidation value does not consider whether a company’s profits exceed its net asset value (i.e., goodwill), liquidation value is generally less than fair market value. However, if the company will be sold instead of liquidated, the value in question would be the going concern value, including the organization’s intangible assets.
The valuation’s purpose plays a critical role in deciding which value to use, ultimately influencing the conclusion. For example, some companies might want to attract outside investment or negotiate a merger deal, while others want to value their business to settle legal disputes.
Not Assessing Company-specific Risk
Proper business valuation carefully examines the risks associated with a specific business or company. Analysts need to consider these risks while using capitalization or discount rates to value the company.
As financial and operational factors differ from company to company, applying generalized capitalization and discount rates without examining if they fit the organization in question is a mistake and can lead to overvaluing or undervaluing a company.
Placing Too Much Emphasis on Revenue or Net Income
Using revenue as a sole metric for determining value may lead to undervaluing a business. As revenue does not mean profit, an increase in revenue does not necessarily translate into an increase in profits.
The times’ revenue method of business valuation does not consider the ability of a company to manage its indirect and direct costs. It is not a reliable indicator of a company’s value.
EBITDA is a better metric to conclude to value than net income. EBITDA adds interest, taxes, depreciation, and amortization, which help normalize earnings by removing factors influenced by the management team. EBITDA provides a clear understanding of the company’s operating performance and cash flows.
Always Including Goodwill for Business Valuation
Business valuation often includes the net value of its assets, plus goodwill (i.e., the “value of a company’s brand name, solid customer base, good customer relations, good employee relations, and proprietary technology“). One mistake is assuming that every business has positive goodwill.
Business goodwill directly relates to its ability to earn profits over its net adjusted assets (i.e., assets fewer liabilities). Calculating a value based on a method that yields a value less than that of a business’ net adjusted assets are erroneous, as a business would not sell for less than its adjusted book value.
Leaving Discrepancies in Financial Statements
Financial statements often show certain discrepancies. Analysts need to ensure that the company makes the necessary adjustments to remove those discrepancies from their accounting records and align them with similar companies. Items that usually need adjustments to include:
- Salaries above industry norms
- Discretionary or personal expenditures
- Non-recurring income or extraordinary expenses, assets, or liabilities.
Including Initial Set-up Costs in the Purchase Price
When a company acquires a business, it needs insufficient working capital for smooth integration, set-up, and continuation. At times, a deferred equipment maintenance cost needs to be deducted from the purchase price. Paying for such expenses in addition to the purchase price reveals an error in business valuation. Valuators also need to adjust for additional income streams the business would generate for the acquiring company to arrive at a fair purchase price.
Underestimating the Business’ Operating Costs
Many hidden expenses go into a business, making it essential for business owners to identify them to a fair valuation. Commonly overlooked items usually include:
- Loss of inventory caused by the time lag between procurement and delivery to the end customer.
- The costs of small equipment and tools that go into the smooth running of a business and improve the effectiveness of their products or services. These may include office equipment like computers, scanners, copiers, desks, paper, chairs, etc., or specific small items that go into a product.
- Costs related to the employees who contribute to the business’ operation and success include staff training, salaries, and benefits. Failure to budget for these costs may result in high employee turnover, increasing recruitment costs, and other expenses. Also, the benefit the previous business owner enjoyed from the target company goes away in such a situation.
Not considering such costs may lead to business failure.
Biased Future Cash Flow Forecasts
Most forecasts include an upward bias, overestimating a company’s growth. Analysts should consider the company’s revenue separate from customers, products, and services. They should employ different metrics to assess how factors such as new customers, old customers, new product offerings, existing product range, etc., will generate revenue.
Also, it is essential to identify and consider the additional costs and challenges associated with developing new customers, products, and services, as failing to do so may not present an accurate picture of the company’s future revenue and cost flows.
The results of the business valuation may influence the success or failure of an M&A deal. Even for an ongoing business, accurate business value helps owners make better decisions that enhance the growth of their companies. On the flip side, an incorrect business value causes a loss of time and money in unnecessary planning, missing out on tax-saving strategies, and efforts spent in the wrong direction.
Correctly calculating the business value of a privately held, small company involves the most difficulty. Different approaches and methodologies are applied in varied situations and help fulfill diverse valuation purposes, using the right ones at the right time. This is where the expertise and experience of professional business valuators will help.
Keeping these business valuation pitfalls or mistakes in mind can help business valuators, analysts, and owners arrive at correct conclusions. Before concluding the organization’s value, they should thoroughly and objectively analyze its industry and consider the internal and external factors affecting the business.