Fundamental to the business valuation process is the need to make assumptions about future events. What the business is worth today depends upon future cash flows. These future business earnings are a function of business future performance, financially and operationally.
Business value is about the future earnings and risk
No matter how you slice it, you need to take a leap of faith and make some critical assumptions about how things will turn out.
Do errors of judgement occur? Yes, indeed. How useful your business appraisal is depends in large part on how well you can foresee the future for the company.
Devil in details – business valuation depends on your assumptions
Both the business appraiser and business clients reading the valuation report must take ownership of the process here. As a business person, you should read the entire report, not just the business value conclusion section. Otherwise, you may miss important assumptions that qualify the valuation result. The body of the appraisal report should tell you how these assumptions have led to the business value number at the end. Equally importantly, you can spot how sensitive the valuation result is to the key value drivers your business appraiser has considered.
In business valuation, the assumptions drive the results. If the assumptions are seen as reasonable by the intended readers of the report, the conclusion should come as no surprise.
If, on the other hand, you find the business valuation conclusion troubling, go back to the assumptions made at the outset. If still in doubt, ask your appraiser to clarify the assumptions or run what-if scenarios under alternative expectations to assess their effect on business value.
If you are working on a business appraisal, a big part of the analysis is reviewing the industry outlook. In many ways, the industry in which the business competes is far more important than the general economic situation. If you are valuing a strong company in a growing industry, its valuation is likely to be higher than that of a failing business that operates in a shrinking industry sector.
As part of your business valuation, you need to determine the overall industry growth potential, and the ability of your subject business to compete successfully. Some of the elements that should go into your analysis are the strength of the management team, the skill set of the key staff, financial condition of the firm, customer base, technology and other intellectual property assets, among other factors.
Your business appraisal report should outline clearly the industry sector and how the company fits into the competitive landscape. Business people and professionals reading your business valuation report should be able to gain a solid understanding of the risks faced by the company, its competitive advantages, and see how your conclusion flows from this thinking.
To make a compelling argument, you would need to provide a well researched description of the industry and the company’s plan on staying competitive. This is necessary in order to come up with realistic business valuation scenarios, such as the forecast of business earnings and assessment of the risks it is likely to face going forward.
Without this foundation, your valuation methods will merely generate unsupportable numbers. Remember the old adage, “Garbage in, garbage out.”
When it comes to business valuation, forecasting the business future financial performance is one of the most challenging, yet necessary tasks. Business value is about risk and returns going forward. Assessing how well you expect the business to do is at the core of establishing its value.
There are two ways to prepare the assumptions about the possible future financial performance of the company. One approach is for the business appraiser to come up with his or her best assessment. An alternative is to use the business management estimates.
Independent business valuations
If you expect the business appraisal to be subjected to serious scrutiny, objectivity of an independent business appraiser is key. This argues in favor of letting the appraiser do the forecasts of business earnings and expenses.
Rosy forecasts and overstated business value
Business management created financials are often rosy and based on aggressive goals. Many business people tend to underestimate the potential pitfalls that sharply limit the company’s ability to achieve such lofty objectives. This is especially the case when a company is facing serious headwinds currently, but hopes the coast will clear in the near future. More trouble ahead may well be overlooked.
The effect of these projections changes your business valuation result significantly. Take, for example, the discounted cash flow valuation method. The forecast of future earnings is a key input. If your cash flow forecast is unrealistic, especially in the early years, the value of the company will be overstated.
Unrealistic business valuation – uncomfortable questions
Valuations that are unexpectedly high are sure to generate skepticism from savvy business people and professional reviewers. An appraiser could state in the business valuation report that the assumptions of company’s management have been used in the analysis. The reader is put on notice, but is still left wondering why the business appraiser went with the management’s point of view.
Independent business earnings forecast – the objectivity advantage
If the business appraiser creates the earnings forecast from scratch, the readers of the business valuation report would likely expect a less enthusiastic but more sober set of assumptions. After all, business appraiser is not bound to endorse high expectations, but rather expected to provide a realistic measurement of what the business is worth.
Has the business appraiser covered all the angles?
The downside is that the business appraiser may not have the in-depth knowledge of the company to make the best projections. As an outsider, you may lack the understanding of the value drivers that can support the earnings growth the company’s management expects.
So what is the best approach? No clear answer exists. Perhaps close interaction between the experienced company management team and business appraiser is the best strategy.
When you face a dispute, whether partner disagreement or legal challenge, the parties are usually wide apart in their expectations of business value. To bridge the gap, keep in mind that a reasonable estimate of the future business outcome is usually achievable. If you expect to be challenged on your business valuation, be sure you or your business appraiser are as objective as possible and the key assumptions underlying your valuation are well supported by facts.
Business valuation controversy – when results are wide apart
Why so many disagreements? When trust between parties is lacking, they expect the opposite side to pressure their appraiser into producing the results they want. After all, they are paying for the business valuation. So suspicions abound: he who pays the piper calls the tune.
When in doubt, go to the key assumptions made in the business appraisal. Take a step back and ask the question, “Do you believe these assumptions?” If you don’t buy the assumptions, explore the alternatives that sound more realistic. See the difference it makes to the business valuation results.
Business valuation in divorce and other disputes
In a legal challenge, you are very likely to run across adversarial positions. The trust between the parties has been broken, and each side is pushing for its own point of view. Expect this to show up in the valuation results. Needless to say, this is immediately challenged by the opposing party.
Objective business valuations are best
Even in the most difficult situations, being objective in your business valuation is the best policy. The goal is to come up with the correct answer rather than push the envelope expecting to make a compromise down the road.
Hidden agendas like this only breed more distrust and endless arguments. Work to get it right the first time.
Sooner or later, this questions pops up for most business people. Whether you are selling or buying a business, hand the reins to a younger generation, seek investment to grow the company, or need to fend off legal challenges, the issue of business value comes up.
Most business people have no clue about business valuation
Now if you are like the typical business person, you are busy running the company. Measuring what it is worth is not the sort of thing you do regularly. The same holds true for most business professional advisors, including CPAs and lawyers. Business valuation is a specialized area that calls for know-how and attention to detail.
Just like with any business chore, cutting corners does not pay dividends. You can ask your business partners for advice, but odds are they know little. Opinions and anecdotal suggestions are no help, most are misleading and overly simplistic. The devil, as the saying goes, is in the details.
How to value a business – a high stakes game
Trouble is, business valuation is about as important a decision making point as it gets. Just consider the amounts of money at stake. Mishandling business valuation is likely to cost you thousands, result in a failed business transaction or a court judgment you will hate. Ask a seasoned business broker and your will hear an uncomfortable statistic: nine out of ten private business sales fall through because the buyer and the seller do not agree on the business value and its selling price.
Courts and tax man use business appraisals aggressively
It gets even more troublesome if you face a legal challenge or questions from the tax man. Courts have a way of enforcing their point of view and you may find a court appointed business appraiser does not agree with your idea of business value. Unfortunately, such business valuations are binding on all parties and professional business appraisers are trusted by courts and tax authorities.
Approach business valuation with respect
Whenever professionals are needed for a business task, you can surmise it is not easy. Indeed, business valuation has a lot of moving parts. For one thing, there are three fundamental ways to value a business. No one way, or approach to valuing a business, is definitive. Put another way, there are several ways to look at what a business is worth. Each approach offers a different perspective. Business appraisers are a detail oriented lot, leaving no stone unturned in their quest for measuring business value.
How to value a business? Three ways to do it
The three ways are formally known as the asset, income, and market approaches. Investing in a business requires capital to acquire business assets. The cost of creating a successful company is considerable. The asset approach seeks to reveal business value based on its operating assets and liabilities.
On the other hand, you can view any business as an income producing entity. Making money at an acceptable level of risk is the key objective and this is the view taken by the income approach to business valuation.
In the real world, businesses operate in a competitive environment. Similar companies can be compared to see what they are worth. Such comparisons are the cornerstone of the market approach.
If you take a look at a professional business valuation, all three approaches are used to figure out what a business is worth. In conclusion, business appraisers like to tie all their findings together in stating the business value. It could be an average of all the calculated values, or a range.
Troubled by business value result? Check the assumptions
One reason business valuations cost good money is that business appraisers are expected to study reams of business information in order to make careful assumptions and express their educated opinion at the end of the report provided to the clients. Such assumptions drive the conclusions of business value. If you have trouble buying the number, go back and review the assumptions.
A trick question: how much capital is committed to the business operations?
If you take a close look at how this method works, you will notice that the net asset value is calculated as the difference between the adjusted business assets less its current liabilities. This net asset value is then multiplied by the fair rate of return to estimate the capital charge, or the amount due on the committed business capital. The greater the net asset value, the higher the capital charge.
Excess earnings – what’s left after return on committed capital
Now for the fun part. The capital charge is next subtracted from the business earnings basis in order to calculate the excess earnings. This quantity gives the method its name. The idea is that a well run business generates earnings in excess of the capital charge thus providing superior return on investment.
Higher excess earnings indicate higher business goodwill
The capitalized excess earnings method determines the value of business goodwill by capitalizing these excess earnings. So the higher the excess earnings, the greater the business goodwill value. Businesses that put more money into the owners’ pockets are associated with higher business goodwill.
Notice that the capital charge is affected by both the total business asset values as well as the current liabilities. Given the asset values, higher current liabilities result in a lower net asset value and smaller capital charge. This in turn leads to higher excess earnings and increases the amount of business goodwill.
Higher earnings with less capital required often result in higher business goodwill
It essentially implies that those businesses able to operate on lower net asset bases have higher goodwill. These companies use Other People’s Money very effectively to finance their operations, usually in the form of short term borrowing from their suppliers.
The secret behind e-commerce success – lower working capital requirements
An example would be an e-commerce online retailer that gets paid shortly after selling the products. At the same time, the company enjoys attractive short term financing terms from its vendors. In addition, it reduces the need for working capital by managing its inventory just in time. The result is lower inventory shrinkage, more economic reordering strategy, and less capital tied up to meet the sales goals.
This is one reason online businesses are often able to out-compete their brick-and-mortar competitors. The online companies do not require expensive real estate for merchandizing and can manage their inventory and other direct selling costs more flexibly. Online businesses tend to focus on efficient and cost effective order fulfillment without the extra overhead of a retail store presence in a high priced shopping mall.
One of the well established business valuation methods, the capitalized excess earnings technique has a long and storied history. The method is described by the United States IRS in its Revenue Ruling 68-609. Unfortunately, the ruling does not specify what it means by the net tangible asset value, a key input into this valuation method.
The business appraisal profession has not formed consensus on the preferred way of estimating the net tangible asset value. Instead, there are several commonly used alternatives:
Gross business assets net of accumulated depreciation, also known as the net current value.
Net current value of the financial and tangible assets less current liabilities.
Net current value of tangible assets minus all liabilities.
Most business appraisers adopt the second definition when valuing a business by the capitalized excess earnings method. This is not to say that the other definitions are less acceptable.
What’s more, the definition you use is not all that important to the results you get with this valuation method. The end result is always the indication of value the business owners hold and as such it should not be affected by the particular definition of the asset value.
How can this be the case? Remember that the capitalized excess earnings method uses two rates of return: the fair rate of return on the net tangible assets and the capitalization rate used in calculating business goodwill. Depending on your choice of measuring the net tangible assets, these two rates of return can vary.
The important part of applying this valuation method correctly is not to dwell excessively on what comprises the asset values. The key is consistency across all choices you make in your calculations.
In other words, the measure of net tangible assets should be consistent with:
The choice of the fair rate of return.
The selection of the excess earnings cap rate.
Make sure your choices match, and the method will provide a supportable estimate of business value, including its goodwill.
Take a look at a typical professional business appraisal report. You will see that a number of valuation methods are used to establish business value. In fact, all business appraisal standards, e.g. USPAP and AICPA SSVS No 1, require that you use all three approaches whenever possible. If you do not, you need to explain why your valuation has omitted one or more approaches from consideration.
A sensible business person can ask: what is the best method to use in business appraisal? Often, the market comparables offer the most supportable evidence of business value. However, the question is how comparable your subject company is to other, similar businesses? Apples and oranges comparisons do happen.
The asset approach is very helpful as long as no significant technological or economic changes have been at play in the market. In addition, business assets should be easy to evaluate as to their physical condition and residual value. Let’s say the equipment or software the business uses have been leapfrogged by new advances in technology. Old machinery or out of date software applications may not be worth much in such cases, so applying the asset approach methods could lead to erroneous valuations.
The income approach methods let you put on an investor’s hat. The biggest challenge is the need to forecast the future financial results for the business. No one has the crystal ball, and your valuation using such methods as the discounted cash flow is only as good as your earnings projections. The assumptions you make drive the results.
Regardless of the valuation methods you choose, business appraisal is an expression of opinion. If your valuation engenders trust, your readers are likely to rely on the answers. When in doubt, consider a second opinion. A different pair of eyes may offer a different view of the business and what creates business value.
One of the key choices you need to make in your business valuation is the length of the financial forecasts. Some experts go as far as to project the business financials over 10 years into the future. In other words, the appraiser takes a leap of faith in order to predict the business earnings, expenses, financial condition, as well the discount and capitalization rates over the next decade.
Crystal ball, anyone?
Ask yourself, what was going on in the financial markets 10 years ago? Yep, the world stood at the door of one of the greatest risks in the market’s recent history. Remember the Great Recession of 2008 that almost sank the markets? It took years to recover from that devastating blow, and in many ways the markets have never been the same.
You have to be a believer to accept that anyone can reliably predict the events that have major impact on the economy, political situation, world events, and technology evolution over a decade. Ask average business people about the crystal ball needed to make such a prediction with any degree of accuracy. Hear them chuckle.
Market risk estimates – discount and cap rates
Financial forecasts also go hand in hand with long-term estimates of the discount and cap rates. Let’s say you put a stake in the ground and claim that the market risks would hold steady over the next 10 years so you can calculate a constant discount rate, say 20% per year.
This constant discount rate is based on the constant estimates of risk-free returns and equity risk premium that go into the Build-Up cost of capital calculation. Unfortunately, the real world experience shows us that constant rates of return simply do not exist. S&P 500 index returns vary over time, just take a look at the last decade’s numbers.
Forecasting business earnings without considering such global phenomena is error prone. Even the best managed companies are subject to the vagaries of the market as a whole. Most businesses have good years and bad when it comes to earnings. Ask the seasoned managers why? They often can’t explain either.
A straight-line linear regression forecast of earnings and expenses is a reasonable model as long as most of the historic conditions for the company continue to hold true in the future. Should this assumption prove false, your ‘business as usual’ financial model falls apart.
The risks we cannot anticipate are all the more likely, the longer the financial projection horizon. If your forecast is way off, the business valuation result will likely be misleading or downright false.
The takeaway is that shorter forecasts are most likely to be a better basis on which to build your business appraisal. The shorter the forecast, the more likely you are to hit the target. Calculating the results on the assumptions that don’t stray from reality is the best way to come up with a realistic business appraisal.
If you look at business appraisals whose results differ significantly, the most common reason is the different assumptions. Consider, for example, the discounted cash flow valuation. If a lower discount rate is chosen by the appraiser, the resulting business value may be understated. On the other hand, an unreasonably low discount rate would lead to a surprisingly high valuation.
When in doubt, consider running several valuation scenarios, each with a different set of assumptions. The results produced cover a range of reasonable business values and may well help dispel skepticism.
When valuation is uncertain: Best case, Worst case, Most likely case scenarios
The same goes for the forecasts of earnings. If you feel a single forecast is likely to be challenged, create several scenarios with different earnings projections. It is common in such cases to use the best case, worst case, and most likely case forecasts. You can use each to calculate the business value result and report them in your conclusions.
This makes sense if you think about it. Business prospects are uncertain, and each may be associated with a different earnings outcome or business risk. While it is not practical to create hundreds of business appraisals, you can reduce the complexity by considering the range of outcomes that are likely to occur. The resulting business value would most likely fall somewhere in between.
Reporting your business valuation: single-point or range of values
Newer business valuation standards, such as the AICPA SSVS No 1, support reporting your business valuation as a range. Doing so may help you convey the idea that a single-point business value is not the best estimate for the subject business. It would be better to state that the value may vary depending on the actual business performance going forward.
Assumptions drive business value conclusion
When looking at two business appraisals that disagree, carefully review the assumptions used in each. Both reports should identify the same key value drivers and risks and provide the rationale for their importance in business valuation. As you read the two reports, you should be able to conclude as to which set of assumptions is more reasonable.