Five common mistakes in business valuation reports

As an entrepreneur, you may need a business valuation for various reasons. The outcome of a business valuation is usually communicated in a formal written report, documenting how the valuation analyst arrived at the business value. In addition, business valuation reports provide important insights regarding the nature of a company’s business, its strengths and weaknesses, risks and opportunities, industry and economic trends, and other relevant factors. This analytical depth can result in business valuation reports of 80 to 120 pages, which can be overwhelming for the reader. But with so much information on these reports, it’s important to understand the final work product so you can feel confident in your experts’ conclusion. Watch for these five common mistakes to keep your business valuation a reliable source for you and your team.

1. Math errors

When reviewing a business valuation, the first important piece is checking the preparer’s math. The report could otherwise be error-free, but a mathematical error resulting in a significant overestimation or underestimation of the company’s value could be catastrophic for that expert’s opinion. Mathematical errors can have a greater impact than one might think, as errors made early in the valuation process can distort assumptions made later. If errors are found in the valuation report, it is worth recalculating the values ​​and reanalyzing previous assumptions taking into account the corrected information. It is also worth investigating whether the expert has made mistakes elsewhere in your report.

2. Apply the asset-based approach without considering intangible value

The asset-based approach usually starts with book value and then converts all assets and liabilities to their fair market value. A common reporting error arises when the valuation analyst includes values ​​for the company’s tangible assets (e.g., cash, accounts receivable, fixed assets, etc.), but does not perform analysis to estimate the value of intangible assets. When properly prepared, the asset-based approach should always include values ​​for the company’s intangible assets or goodwill, if any. Nevertheless, the process of measuring intangible assets can be very complicated and for most operating companies the revenue and market approaches are a more efficient way to capture both the tangible and intangible value of the company, so the asset based approach is often not used.

3. Apply both the CCF and DCF method under the income approach

Another common reporting error occurs when the valuation analyst applies both the capitalized cash flow (CCF) and the discounted cash flow (DCF) method under the income approach, then weights the results to form a single indication of value. However, since these methods are mathematically linked, the CCF is an algebraic simplification of its more detailed DCF counterpart, and they are mutually exclusive; which means the valuation analyst must apply or the CCF or DCF method, not both. Deciding which earnings approach method to use depends on the facts and circumstances, including, but not limited to, whether the company is in a mature or growing business cycle, whether budgets or projections are made in the normal course of business, and whether historical performance of the company gives a reasonable indication of the future. Regardless of which method of the income approach is used, the business valuation report should always state why one method was considered superior to another.

4. Over-reliance on rules of thumb

Using a rule of thumb to value a company is a simplified form of the market approach, where an industry-specific multiple is applied to the respective company’s income or earnings to obtain the company’s estimated value. For example, average full-service restaurants sell for 30 to 40 percent of annual sales, or typical dental offices sell for 2 to 4 times EBITDA. These multiples are considered price tips by business brokers and can be found in various publications and magazines. While easy to apply, rules of thumb are generally too broad to be of much use in valuing a company, and there is no agreed upon definition for the financial measures used. Furthermore, rules of thumb are rarely, if ever, used as the sole means of valuing a company since so many other factors (e.g., customer base, cost structure, location, local competition, debt, cash flow, etc.) are considered.

5. Lack of support for the why

Many business valuation reports contain a general lack of support for subjective factors, or the analysis is just a statement of facts with no discussion of why. For example, if a company’s sales have increased at a five-year compound annual growth rate of 10 percent, a thorough report would discuss the factors driving that growth. Has the company released a new product? Hire more sales staff? Opening a new location? Acquiring an important new customer? Increase prices? Moreover, if sales growth is expected to continue for the foreseeable future, the reasons for this continued growth should be stated.

A detailed business valuation report should tell the story of the business and explain the thinking process of valuation professionals while analyzing the business so that the reader has confidence in the conclusion of value. If that is not done properly, the value conclusion is not very convincing. However correct the conclusion of the value may be, it may not be accepted by a testing partner if the valuer does not provide sufficient detail and explanation of how he arrived at that conclusion.

Help you get there

There are plenty of other mistakes to carefully avoid in business valuation reports, including: