Business valuation: beware of bad private company data
Market approach to business valuation has a lot of appeal – it offers evidence directly from the market place where the actual business buyers and sellers negotiate company selling prices. If you get hold of enough sales data, the reasoning goes, you should be able to estimate the value of a similar business. The market is seen as the ultimate judge of what a business is worth.
So far so good, but the devil is in details. First of all, what data can you get for privately owned companies? Secondly, how reliable is the data when it comes to valuing your business?
Issues with private business sales data quality
The major issue with data quality is that no private business is obligated to report its financial or operational data to the public.
This is in stark contrast to the public companies that are under the scrutiny by the government established regulatory bodies, such as the US Securities and Exchange Commission (SEC). Every company that sells its stock to the public must regularly report is financial and operational condition. All this information must be disclosed publicly and can be studied at no cost to you. See SEC’s EDGAR database online for details.
Consistent financial reporting is key for market comparisons
To make the public company data even more useful, all financial reporting must be done in compliance with major standards such as the Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS).
This helps you make ‘apples to apples’ comparisons when you examine the market evidence of business selling prices in relation to financial performance metrics such as net income, EBITDA, cash flow, or business assets.
If you get a hold of private company financial statements or tax returns, you will quickly discover that no such consistency exists. Private companies do not sell stock to the public and thus are under no obligation to provide standards compliant financial numbers. This hampers your ability to develop reliable valuation multiples without in-depth knowledge of how each comparable company reports its financial performance.
Reasons private data services on business sales are unreliable
There are a number of private data services offering business sale data for a price. You should be very careful when using such data in any defensible business appraisal. Here are the typical problems:
- Only a small percentage of private business sales ever get disclosed.
- Financial data is collected by people who lack financial reporting expertise.
- No business sale background data is available as private companies typically wind up and dissolve following a sale.
- No background is offered to help you with financial adjustments needed to calculate valuation multiples.
Most private business sales go unreported
Most small business sales ‘fly under the radar screen’ with deals being done directly by business buyers and sellers. Since private data services rely upon business brokers to get their data, such sales never get reported. The result is that the business sales statistics are greatly skewed by the few reported deals and miss the large number of actual transactions.
Private company financials provided by players with little financial reporting training
Business brokers typically are not accountants and lack the necessary expertise in financial reporting. So one broker’s discretionary cash flow may well differ from the next. The result is that you might be comparing ‘apples with oranges’ when trying to calculate your company’s potential market value.
No background info on private business sales
Doing financial statement adjustment is a crucial step in private business valuation. However, to do this you need to have background knowledge of the company. Such information is very hard to come by and typically is not offered by private data services. The result is that you are operating in the dark when trying to assess the profitability of sold companies. Your valuation multiples may be way off base and lead to erroneous business value estimates.
Stale data, duplicate records, typos, and sweetheart deals to confuse you
Many private data services are all too eager to make a buck by selling you low quality data. Some of the more common problems with these sources of business sales:
- Obsolete business sales records, with some industry sectors having just a few sales reported over a number of years.
- Duplicate records that inflate the number of useful transactions.
- Missing fields in business sales records.
- Outliers which can seriously compromise the accuracy of your calculations.
No plug and play data – review your numbers before using!
Whatever you do, make sure you carefully review the data you get from these data services before using it in your business valuation calculations. The old adage ‘garbage in, garbage out’ is a constant reminder.
Guideline public company method to the rescue
If you are valuing a business in an industry sector with many smaller or mid-market public companies, you are in luck. You can take advantage of the much more reliable public company data to calculate the valuation multiples. Using these guideline company multiples gives you a comparable estimate of business value on a fully marketable basis. Since private firms are less marketable, you can then make the adjustment by using discounts for lack of marketability.