How can you tell if a business valuation is correct or if it is likely to be biased, wrong, or outright rigged?
In the majority of business valuations, the business valuator follows accepted standards and delivers a supportable and unbiased valuation.
Unfortunately, a few business valuations are incorrect or inappropriate. Often this result is more because of inexperience or unrecognized bias rather than outright intention.
Below is a list of errors that sometimes can be identified by non-experts. Business valuations for the IRS, or ESOPS, GAAP, or litigation are very technical. Make sure the business valuation you are relying on or reviewing is correct. Another view on rigging a business valuation is presented by Jim Hitchner here.
Common errors include:
- The wrong standard of value. Standards of value are standardized assumptions around who are the agreed upon buyers, sellers, timing, and other details of a sale. The wrong standard of value will subtly change many things in the valuation and often lead to an improper value.
- The wrong valuation date. The valuation date is the cut-off date that the valuation is done through. For some valuation purposes the valuation date is critical. For instance, consider the value of a restaurant serving a tourist destination on a far-off island the month before Covid-19 shut downs and the month after. For some purposes the valuation date moves. This is common in divorce. The wrong valuation date can result in a wrong value.
- The cash flow being applied against the wrong multiplier or discount rate. For instance a SDE (Sellers Discretionary Earnings) cash flow being applied to an EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization) multiplier; a non-tax adjusted cash flow being applied to a standard tax adjusted build-up. This can greatly skew value and is not always as obvious to spot as it sounds.
- Too Good To Be True, almost miraculously better or worse current year (or previous year) results than earlier periods. In some industries, many aspects of the accounting statements are based on allocations that can be tinkered with. Are gross margins consistent, were all expenses entered, are the period cut-offs correct? Does the economy, industry, company factors and more support the numbers? There may be a very good reason for the change in results, but make sure the situation makes sense.
- Suspicious add-backs, one-time events, and so on. Adjusting entries to create “apples to apples” financial statements for comparisons to market data or discount rate data is essential. It is also a major area for error and trouble. Make sure comparability, one time, and discretionary adjustments meet the definition for the cash flow being used and are properly supported.
- Cash flow weighting that is not supported by facts. Both the market method and the capitalization of earnings method weight historic cash flows to estimate a future cash flow value. This weighting should be done to tie into expected future results as reasonably influenced by the past and future expectations. Intervening events can make historic cash flows susceptible. This calculation is easy to miss and can greatly swing results.
- Hockey stick projections. Similar to miraculously better financials are projections into the future. Companies that claim they are going to “take-off” next year. Certainly that could happen but support should be very strong and the discount rate should be higher to justify a value found.
- Unusual or doubtful discounts, capitalization rates, and market data multipliers. These are all adjustments to reflect the risk of making or not making the required cash flow return into the future. The comparison set needs to be reasonably tied into the situation with the subject company. While the discount rate or multiplier is a simple number, estimating it requires experience and professional judgement.
- A final value after all adjustments and balance sheet adjustments that is above a 100% financed business at 8%. This is extreme, but it happens, most often with very high inventory or receivables businesses. Again, the finance method is a great sanity check. In the Finance Method rule of thumb, you work back from the cash flow to estimate the loan principal amount it will support.
- Cash Leakage. At the other extreme, a long-term high revenue business in a “cash” industry with very low gross margins and no value. While it could be a huge discounter, it may also indicate cash leakage and requires additional review.
- Cherry picking. Namely, almost every choice was favorable to very favorable for a higher or lower value. Consistent but unjustifiable small gains or losses at every turn can greatly change the value found.
All of these issues, other than the first two issues, could be explainable and even correct. But, if these factors are present, look hard and ask questions before signing that the value found and the report is correct.
Conclusion:
If you are reviewing a business valuation you should make sure it is correct. The book, “The Art of Business Valuation, Accurately Valuing a Small Business” has 400 pages covering many professional judgement, calculation, standards, and other important valuation issues along with access to sample reports, calculators, and checklists downloadable from the web. This will be the one book you will reach for if you value or rely on valuations of micro or small businesses with revenues under $10 million. The book published by Wiley is available at your preferred bookseller. More information can be found at www.theartofbusinessvaluation.com
Finally Greg Caruso, JD, CPA, CVA, the author is always available to prepare (or review) business valuations for all purposes and situations.
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