If you are looking at a business valuation result that just doesn’t make sense, chances are there is a mistake. An error can creep into your business valuation in a number of ways. Here are the top ones to watch out for – and avoid when valuing your business:
1. Choosing the wrong type of business value.
Business valuation results depend upon what type of value is being measured. And the most common standard of value used in business appraisals is fair market value. However, many business valuations are actually done under the so-called investment standard of value.
This is especially the case if the business is valued in order to attract outside investment, large corporate acquirers, or in cases of legal disputes. But the assumptions made and, therefore, the results of business valuation under such diverse value standards can differ considerably.
2. Measuring business value against the accounting profits instead of cash flow.
Business value depends largely on its earning power. And the most direct measure of business earning power is cash flow, not net profit.
For business valuation purposes, you should use Seller’s Discretionary Cash Flow or Net Cash Flow as the earnings basis. Moreover, you can estimate these by recasting the company’s Income Statement and Balance Sheet.
3. Assuming that every established business has positive business goodwill.
You may have run across this common view of business value: it is the sum of the business tangible assets and goodwill. Bear in mind though, that business goodwill is directly related to the business earning power.
The business appraiser’s view is this: business goodwill exists if the business is able to generate earnings over and above a fair return on its tangible assets.
If the business earnings fall below the fair return on its assets, then you have negative business goodwill. The well-known Capitalized Excess Earnings method helps you measure the business goodwill and total business value – directly from the business asset base and its earnings.
4. Using the wrong valuation multiples.
If there is one reason business valuations go wrong, this is it. There are a number of valuation multiples used to estimate what a business is worth. Each relates a specific measure of financial performance to the potential business selling price. Use caution when applying these valuation multiples – if the multiple is based on the business Net Cash Flow, do not apply it to its net profit!
5. Leaving out key assets and liabilities from business valuation.
Most small business transfers are done as asset sales. The seller pays off all business liabilities and retains the cash and accounts receivable.
Typical market-derived pricing multiples are based on the asset sale assumption. If you use such pricing multiples, be sure to adjust your business value result to account for all the assets and liabilities involved in your specific situation.
As a rule, additional assets acquired by the buyer increase the business value, any liabilities assumed decrease what the business is worth.
6. Failing to assess your company-specific risk.
Risk assessment is a key factor in any business valuation. Using capitalization or discount rates that do not account for your company’s specific risk profile can lead to very misleading results. Each company has a number of financial and operational factors that contribute to its risk profile. Hence, your discount and cap rates are unique to your company.
See how to assess your company’s risk – and avoid this nasty mistake in your business appraisal!
7. Thinking that the business purchase price and project costs are the same.
If you value the business to buy or sell it, don’t forget to make several important adjustments:
- The business buyer also needs to inject adequate working capital. In an asset sale, this is over and above the purchase price.
- Deferred equipment maintenance costs. Deduct these costs from the purchase price.
- Investments required to maintain the business income stream: hiring staff replacements, regulatory compliance, licenses. Adjust your business value by the appropriate amount.