5 Common Errors In Business Valuation
A business valuation is used to achieve the fair value of a business, which can help in many situations like income tax reorganisation, related party transactions, shareholder disputes, acquisitions and mergers, divestitures and obtaining notional value. Hence it is highly used.
Business valuations need to be consistent and have almost zero errors to achieve purposeful and relevant results that support actual transactions. There is even a library of references to help ensure this. However, errors and inconsistencies still happen frequently and dire consequences will usually follow.
There are five mistakes often committed in business valuations that we shall review in this article. The following summarises the methods to avoid the 5 common errors in business valuations:
1) Unrealistic Cash Flow Projections
As future income and expenses of a business contribute to its value, cash flow projections play a vital role in business valuation. Unfortunately, cash flow projections are still just guesses, hence they naturally carry errors and inconsistencies.
Greater Awareness Of These Usual Errors And Inconsistencies May Help Reduce Their Effect On The Resulting Business Value:
● Optimistic revenue expectations
It is usual for cash flow projections to have an upward bias - or overestimate - on its expected revenue.
One way to overcome this is to breakdown the revenue according to existing and new customers, products, services and other parameters. This helps to evaluate the magnitude of growth in revenue caused by the new customers, products and services.
With this expected growth of revenue, the impending costs and challenges involved can be further identified. Identifying the ways in which the expected growth is obtained helps keep the mind grounded and the expected revenue realistic. Though the process may challenge objectivity at times and involve laborious tasks, it is crucial to have detailed cash flow projections.
● Inconsistent accounting of operating expenses
Expected revenue must correspond to the operating costs as one begets the other. Hence there must be sufficient accounting of the required operating costs for an expected revenue.
Many cases of revenue projections leverage on existing infrastructure costs, which raises the profit margin and henceforth increases the derived business value. Such errors can be mitigated with the use of analytical tests in the business’s financial model.
These tests can be measuring the revenue per employee and other operational aspects, and they would help keep the expense projections fair and sound.
● Additional capital expenditure
Business expansion will increase fixed assets. Such additional costs become significant when facilities expansion is needed for the revenue growth. Business valuation should then include the use of capacity utilization metrics meant for facilities, distribution and other related aspects of the business to evaluate the needed amount of additional expenses.
● Changing working capital requirement
When revenue increases, it is common that the accounts receivable, inventories and other existing assets will follow suit. Higher accounts payable, accruals and deferred revenue will then partially offset these impending increments.
However, a revenue growth also brings about an increase in the working capital requirement, which reduces the cash flow and subsequently the derived business value. Hence it is vital to know the extent of the working capital requirement to avoid unnecessary errors.
This can be done as accurately as possible using metrics like taking day sales outstanding, inventory turnover and net working capital as a percentage of revenues.
2) Sole Reliance on the Multiple of EBITDA Methodology
Very often business valuations are carried out using the Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) method, where the value of a business is derived from the multiple of EBITDA.
However, the EBITDA method tends to lump the key drivers of business value (like the capital expenditure requirement, income tax or the working capital for business growth) into one valuation multiple instead of considering them individually - and this becomes problematic later on.
Hence business valuations should not depend only on the result of the EBITDA method, but consider it as a preliminary indication of the business value, or use it to test the results of other valuation methods for consistency and validity.
3) Misconceptions in Comparable Company Multiples
Business valuations normally take reference from the multiples of comparable businesses to tackle the impact of the changing industry and economic conditions, and keep their results relevant and reliable.
Caution Must Be Exercised When Using Data Of Companies and Recent Transactions For Referencing Comparable Company Multiples:
● Although publicly listed shares are small lots of high liquid securities with known prices, their liquidity and price discovery are not considered for the en bloc valuation. This presents a difference between valuing a public business en bloc and by the trading prices of its shares, which is then considered in its valuation multiple.
● Compared to private businesses, public ones are normally larger and more diverse. Hence public businesses are less of a target for open market transactions or notional valuation.
● In any industry, small businesses tend to be acquired at valuation multiples lower than that of their larger equivalent.
There Should Not Be Over-Reliance On Valuation Multiples Used In Open Market Transactions As They Can Have The Following Misconceptions:
● The base of EBITDA Multiple
The disclosed EBITDA multiples could have been calculated from the actual EBITDA instead of the normalised one, which would have helped make the necessary adjustments for the unusual items and the excessive or deficient accounts payable.
● Terms of the deal
The derived business value could have been altered by non-cash terms like promissory notes, share exchanges and earnouts. This would then change the resulting valuation multiple.
● Relative negotiating position
The final business value could have been altered during the negotiation phase when one of the involved parties has a stronger negotiating position than the other. As influences to individual negotiating power are never made known, their impact can only be assumed.
4) Technical Errors in Determining the Rates of Return and Valuation Multiples
There is essentially more subjectivity at work when identifying a suitable figure for the rate of return or valuation multiple to use in a business valuation. Even so, the figures must be realistic and the process of determining it consistent for the valuation results to be reliable and purposeful.
It Is Vital To Be Conscious Of The Common Technical Errors In Working Out And Using Rates Of Return And Valuation Multiples, To Avoid Or Minimise Their Unwanted Effect:
● Inconsistent denominator for the rate of return and cash flow
When the discounted cash flow is based on the cash flow prior to debt payments - unlevered free cash flow -, the discount rate should be stated as ‘weighted average cost of capital’.
● Double-counting of risk factors
In the case of ‘small business risk’, when a risk premium is included, this risk premium should not be used again in matters like limited market presence.
● Double-counting of growth
When a cash flow projection has included a growth element, this growth element should not be considered again in the rate of return or valuation multiple.
● Exaggerating long term growth rate
A discount rate considers the risks of a business, its industry and the generic economic influences. A long term growth rate involves the long term inflation rate - and sometimes, the real growth rate, which also considers the inflation rate. This real growth rate signifies the capacity of a business in achieving returns greater than its capital.
Over time, high real growth rates generally become challenging to reach as the impending pressure from competitors will also increase - a natural occurrence in any industry. Hence exaggerating a long term growth rate will then blow the result of a business valuation out of proportion.
So the capitalization rate should be used as the discount rate, which involves a shorter term growth rate.
5) Ignoring the Balance Sheet
Business valuations are normally more attentive to cash flow projections, and less on the balance sheets, which actually have the list of all the net operating assets a business needs to achieve that said cash flow.
A substantial business valuation should involve the analysis of normalised non-cash working capital, which are essential for a business operation. This includes the accounts receivable and payable, inventories, deferred revenues and etc.
When the actual amount of the working capital changes against the estimated normalised amount, appropriate adjustments should be made to the resulting business value regardless of the time of valuation. Such adjustments, though reasonable, are often forgotten when a business is inherently seasonal.
The business valuation should also first evaluate the necessity of any accessible cash - or cash on hand - for the business operating capital before including it into the business value. This would avoid any errors following the unnecessary inclusion.
Lastly, the substantial business valuation should consider all redundant assets to avoid downplaying the resulting value of a business. These redundant assets can be excluded without interrupting a business operation, and hence are easy to miss. Fortunately, they are recorded in the balance sheets.
The Following Lists Some Of The Redundant Assets Usually Missed:
● Accounts Receivable
This includes, where applicable, money owed to the business due to reasons not related to its operations - non-trade receivables. Such cases may involve employees or even shareholders.
● Fixed Assets
These include facilities that are not used and/or can be eliminated.
● Real Estate
When business is run in a self-owned real estate - or property -, the real estate needs to go through its own valuation. A good property tends to achieve a valuation multiple higher than that of the business operations. This multiple is then a vital influence on the overall business value.
Valuing a business is a science as well as an art. Achieving a reliable and relevant result is only possible through a meticulous and non-subjective analysis of the business and its industry, using viable valuation methods in an appropriate and a systematic way.
Would you like to avoid these common errors when valuing your business? Speak to a business valuation specialist in Singapore for free today.