You may wonder: is it possible to use the established business valuation methods and still come up with erroneous results? You bet. Moreover, it happens all the time, even in professional business appraisals.
The culprit is, as usual, between the chair and the computer screen, as the saying goes. Put seriously, your assumptions, depth of business value analysis and attention to detail determine how accurate your business valuation will be.
Consider some typical examples of errors creeping into business valuation each and every day:
Bad market comps
This is probably the most common mistake business people make. Scare up some business sales data real quick, calculate valuation multiples in a hurry and, bingo, you have an estimate of business value. Right?
Not so fast. Comparing apples to oranges serves to mislead, not enlighten. For instance, are the data you put together relevant and reliable? Moreover, are the companies in your comparison data set similar to your subject company? Have you let some outliers into your valuation multiples calculations?
Stray but a little, and you have a bogus business value estimate.
Using wrong earnings basis
Now you would think that such a razor sharp business valuation method as the discounted cash flow would always hit the bull’s eye. Not necessarily. The business value result depends on your definition of the cash flow and the discount rate.
Are you valuing the business enterprise value? Then the net cash flow to total invested capital is the right earnings basis to use. Or are you trying to figure out the owners’ equity value? Then the net cash flow to equity is the right choice.
Your discount rate calculation must match your company’s risk profile. Take a look at the standard Build-Up model and WACC calculation details. Misstate the elements of your discount rate and your valuation results are rendered worthless.
Perhaps the most challenging part of the discounted cash flow valuation is carefully estimating the long-term earnings growth rate. Companies may be going through a temporary growth spurt that far exceeds a sustainable pace over the long haul. If you overestimate the earnings growth rate, your terminal value calculation will be too large inflating the business valuation result.
Are all these assets really used in the business?
Many privately owned companies carry assets on their books that have questionable value to the business. Some typical examples that skew your business valuation results are real estate, excess manufacturing or warehouse capacity, obsolete equipment, or just plain old assets long since retired from service but still kept on the books.
Such non-operating assets should be carefully reviewed and their value adjusted in order to prepare for business valuation. Check your industry sector best practices on real property and equipment requirements to compare against your company’s situation.
One benefit of a thoughtful asset analysis is being able to demonstrate business goodwill. If you are using the capitalized excess earnings valuation method, the return on the tangible business assets reduces the excess earnings figure. If your asset base is overstated, you will undervalue the business goodwill.