Common mistakes in company valuations

Every day, companies, large and small, public or private, are subject to Company Valuation procedures. Despite the great strides in the valuation literature and the educational pathways developed that allow practitioners to “upskill,” I am still amazed at the number of mistakes made when undertaking engagements of this nature.

Here are three of my favorite tips to avoid these mistakes when valuing your business:

1) Future Maintainable Earnings (“FME”) and the ‘Average of 3’

When applying an income approach and more specifically the FME capitalization methodology, it is common for the FME to be calculated by averaging the earnings obtained in the last three years. This practice is inherently flawed and at odds with the FME concept that requires a prospective, not retrospective, approach to assessing earnings.

Errors in the average of historical results are magnified during periods when wages, rent, or other material costs rise rapidly. Also, recent changes, such as relocations to larger (and more expensive) facilities or an expanded workforce, are not adequately captured. Price changes and any deviation from historical gross margins are also ignored in the averaging process.

With so much time invested in multiple gains, it’s a shame FME’s determination doesn’t deserve the same scrutiny.

2) Understand economic drivers

Now more than ever, businesses are subject to seemingly constant change. Technological disruption is sinking some industries while others seem unstoppable. From a valuation context, it is important to be aware of external factors that affect the key drivers of the business in question.

Research house IBISWorld publishes its views on industries poised to ‘fly and fall’. History is clearly a poor guide when valuing companies at either end of the spectrum. In 2015, the suggested underperformers are those in the manufacturing of mining and construction machinery. News agencies and video stores have been named in previous years. The best ones include online groceries and hydroponics. A thorough understanding of the industry can help avoid unrealistic valuation conclusions.

3) Lack of cross-checking

The practice of Valuation is a highly subjective discipline and absolute agreement among practitioners is rare. Despite this, the process of cross-checking the conclusions is essential to confirm or reject the claims made. It can be used to adjust an assessment range, rule out erroneous conclusions and ensure that the results take into account the ‘real world’.

Cross checks should include alternative methodologies to validate or discredit the main approach. In addition, conclusions based on theoretical inputs, such as betas, alphas, and bond rates, should be compared with industry and economic expectations to ensure that conclusions do not diverge too much. If a chicken looks like a duck and sounds like a duck, it may actually be a duck! In other words, if the scope of the valuation requires an assessment of fair market value, does the result represent a value that would be acceptable to the market?

Conclusion

The subjective nature of business valuations requires professionals to step away from ‘autopilot’ and rigorously challenge methodology, inputs and especially outputs before going to print. Currently, there are only 98 CAANZ accredited business valuation specialists in Australia and New Zealand. Contact one of our team who can work with you to navigate the intricacies of valuation and provide products that are fit for purpose.