Everyday businesses, large and small alike, are subject to Business Valuation procedures. Despite significant advances in valuation literature and educational pathways that allow practitioners to ‘upskill,’ I am still shocked at the number of errors made when engaging in this type of engagement.
These are my top three tips to avoid making costly mistakes when valuing your company.
1) Future Maintainable Earnings (FME) and the “Average of Three”
The Income Approach, and specifically the capitalization of FME methodology, often calculates the FME by adding the earnings over the last three financial years. This is a flawed practice that conflicts with FME, which requires an forward-looking approach to assessing earnings.
In periods of rapid increase in wages, rent, or other material costs, the errors in the average of historical results can be magnified. Recent changes, such as the relocation of larger premises (and thus more costly) or an increase in workforce, are not properly captured. The averaging process does not take into account price changes or deviations from historical gross margins.
It is regrettable that FME determinations are not subject to the same scrutiny as the laborious work involved in determining the multiple.
2) Understanding Economic Drivers
Businesses are now more vulnerable than ever to technological disruption. Some industries are being destroyed by technological disruption, while others seem unstoppable. It is important to consider external factors that impact the key drivers of the subject company when valuing it.
Research house IBISWorld shares their opinions on the industries that are set to “fly or fall”. The past is not a good guide for valuing businesses on either side of the spectrum. The manufacture of construction and mining machinery was a likely underperformer in 2015. In previous years, news agencies and video stores were named. Online grocery and hydroponic crop cultivation are two examples of outperformers. It is possible to avoid making unrealistic valuations by having a deep understanding of the industry.
3) Crosscheck Failure
It is difficult to reach an absolute agreement among practitioners in the Valuation discipline. Cross-checking conclusions is crucial in validating or rejecting assertions. This can be used to narrow a valuation range or to reject erroneous conclusions. It also ensures that outputs are in line with the “real world”.
Crosschecks should also include alternative methods to discredit or validate the primary approach. To ensure that conclusions based upon theoretical inputs like betas, alphas, and bond rates are consistent with industry and economic expectations, crosschecks should also be done. A chicken that looks and sounds like it is a duck may actually be a duck. Also, the scope of the valuation must be used to determine fair market value. Does the result represent an acceptable market price?
Because business valuations are subjective, practitioners must be able to challenge the methodology, inputs and even the outputs before going to print. Only 98 CAANZ-accredited Business Valuation Specialists are available in Australia and New Zealand. Get in touch with one of our experts to help you navigate the complex world of valuation and deliverables that meet your needs.