Business valuation or Business appraisal is the process of enumerating the value of an owner’s interest using predetermined formulas and a set of methodologies. A business value means different things to different people, that’s why business valuations are nothing but opinions of value. Business valuation is an essential for countless business owners that can influence their decision to sell, continue or even adjourn a project.
Business valuation can steer a proposition either way. It is typically evaluated for the following reasons:
- Buying/Selling a portion or all of the business
- Estate Planning
- Corporate or Partnership dissolution
- Establishing values of a decedent’s estate
There is an assessment of businesses that are currently operating all over the world, and no matter their size, they should all be valued at critical points in their lives. However, there is a right and a wrong way to value a business.
Chances are that mistakes might arise in business valuation reports and they can seriously harm a business. Miscalculations can creep into your business valuation in a number of ways. Here are a few mistakes that can inflate business value and how to avoid them.
1. Measuring business value against the accounting profits instead of cash flow
Business value depends largely on its profitability, financial health and earning power. Two metrics to measure this are the Accounting profits and Cash flows. The difference between the revenue received and costs incurred gives us the Earnings or Profits of the company. Profit is the overall picture of a business, and the basis on which tax is calculated. Cash flow is the net change in the company’s cash position from one period to the next. If you fetch more cash than you send out, you have a positive cash flow. Cash flow is a key indicator of financial health. Cash received by the company causes the cash flow to go up but the net income remains the same. This tell us that cash flow and net income are not identical, it’s just that they are recorded at different times. In conclusion, we learn that Free Cash Flow is a better metric to analyze profitability than earnings. The two main reasons for this are:
- Revenues and Expenditures are accounted for at the right time
- Cash flows can’t be manipulated as much as Earnings
2. Using the wrong valuation multiples
Valuation multiples are an elementary part for any valuation and are incorporated into different approaches. They are derived by the analysis of various financial statements and other operational factors. As an example, Valuation multiples generated from similar business sales are used to estimate the probable selling price of a business. A few of the sought after multiples are:
- P/E ratio
- Price/Cash flow
- PEG ratio
Each multiple is an expression of a specific measure of financial performance to the potential business selling price. Valuators should take great care in their use– if the multiple is based on the business Net Cash Flow, do not apply it to its Net profit!
3. Leaving out key assets and liabilities from Business Valuation.
Quintessential market-derived pricing multiples are based on the premise of asset sale. If such pricing multiples are being used, be sure to adjust for any business or company specific risks for all the assets and liabilities in question. Customarily, incoming assets into the business increase the business value, any liabilities assumed decrease what the business is worth.
4. Failing to assess your company-specific risk.
A careful examination of any estimates of risks that may arise is a key factor in any business valuation. Using capitalization or discount rates that are not a narrative for the company’s specific risk profile can lead to spurious results. Each company differs in its financial and operational factors that contribute to its risk profile. Hence, such discounting rates should be used that are unique to your company.
5. Thinking that the business purchase price and project costs are the same.
In case of a business acquisition, the buyer will need to infuse adequate working capital into the company. This supplemental working capital is over and above the purchase price at the time of a business sale. Another situation that requires adjustment can be deferred equipment maintenance costs which need to be deducted from the purchase price. Valuators need to be sure to adjust for such costs and other incomes streams to get an unbiased purchase price for a business.
6. Assuming that every established business has positive business Goodwill.
A common perception about Business Value is: it is the aggregate of the business tangible assets and goodwill. One should be mindful of the fact that, the business goodwill is directly related to the remunerativeness of the business.
A business appraiser’s view should ideally be: Business goodwill exists if the business is able to bring in earnings on top of a fair return on its tangible assets. If the earnings fall below an acceptable return on its assets, this gives rise to negative business goodwill.
Some business proprietors may feel like they’re going strong and doing well, but they may merely be competent enough at running their businesses on “Vapor”, meaning they can conveniently use credit generously granted to them by certain vendors that reduces working capital requirements. This portrays a biased picture of the business.
8. Hidden Operating Costs
It is very important for a business owner to first get educated about the expenses that go into a business. There are businesses that remain highly efficient and always try to find a way to bypass operating costs. A few of the overlooked items are:
- Shrinkage refers to a loss of inventory due to the time lag that occurs between its purchase from the supplier and its purchase by the customer.
- Equipment and upgrades. An owner should be aware of all the tools that go into running the business and are required to run a product or a service. It can so happen that small equipment can be forgotten in the mix. One should remember to include elementary office equipment in the budget, items like computers, copier, paper, scanner, desks and chairs.
- Employees and Benefits. Apprentices and other staff members that help your business run, significantly influence its success. Costs like salaries, social security, personal leaves, Medicare and training costs should be factored into the budget. Shortcomings in proper investment in employees can lead to high employee turnover. This can lead to several costs not only in the form of turnover costs, but also the loss of potential the former employee carried.
Underestimating costs like these is a crucial pointer towards business failure.
9. When to “normalize” financial statements.
There may be some discrepancies in some elements of the financial statements that may not be considered “normal”. Certain adjustments should be made to the financial statements so that they are at the same level as the comparable companies. Some items that may command adjustment are:
- Higher management salaries and perquisites that may be above normal level.
- Depreciation policies
- Unusual or non-recurring income/expenses
The valuators not only need to be sure that appropriate adjustments have been made, but should also be able to support them.
10. Choosing the wrong type of business value.
Business valuation results will differ based upon what type of value is being measured. A few of the frequently used norms of value are:
- Fair Market Value. The most feasible price that a property, asset or business could bring in a competitive auction setting or a fair sale. It is an approximation of the market value based on what a willing, able and well informed buyer might pay to a willing, able and well informed seller in the market.
- Investment Value. Value of a property, asset or business to a particular investor. It is based on the ability of the investor to put the asset to use in its highest and best way. It might differ from the Fair market value.
- Liquidation Value. It is the price of the tangible assets in a situation where a company is going to be liquidated. It is usually lower than the Fair market value as there is no open market sale taking place. If a company would rather be sold than liquidated, the value is called the Going Concern Value which would also include the value of intangible assets along with the liquidation value.
Different values are calculated according to the use, which can be to attract outside investment, negotiating a merger deal, or in cases of legal disputes. Valuation results can vary considerably depending on the choice of the value.
Business valuation is a critical element to estate or business succession planning. The business maybe an owner’s largest asset and at some point they will need to determine the taxable value of their business interest. An underestimated value could lead to missing out on tax-saving strategies, while a value that is inflated could result in an investment of time and money in unnecessary planning.