By Gregory R. Caruso, JD, CPA, CVA
In the July/ August Issue of The Value Examiner, the publication of the National Association of Certified Valuators and Analysts (NACVA), I wrote about two common mistakes I see when valuators use the income approach with small businesses. Here is an overview of those two mistakes, or you can read a PDF of the article by clicking this link:
Understating company-specific risk in business valuation.
In my last blog post, I explored some of the concentrations and risks that small businesses face. The risks that large companies have are not the same risks that small businesses have. The income-based method captures risk with the company-specific risk premium (CSRP), but I’ve seen this understated too many times. I explain in the article that different methods will give different discount rates, and those will change the value of the company. Valuators who do not regularly value small businesses often understate the risks associated with them.
Understating long-term growth for early-stage and growth-stage companies.
The second mistake I often see is understating the long-term growth of small businesses in an early or growth stage. For example, using a 10% growth rate in the capitalization of earnings method gives you completely unrealistic results for cash flow over time. However, because present value discounting is also part of the process, it may not give you an unrealistic business value. In the startup and growth stages of a business, that business might experience annual growth rates of 100% range or more, but often average 10–35%. At some point, the companies level off. Knowing the business growth cycle and which phase the business is in helps you evaluate cash flows and the company more accurately.
Valuation is an art and a science, and often experience and practice helps with understanding the art. Contact me to learn more about my valuation services or learn more about the Art of Business Valuation in my book.