Valuations: 5 Mistakes Your Business May Be Making

Valuations: 5 Mistakes Your Business May Be Making

A valuation report has many moving parts, as such it is crucial to ensure that all the constituents of the report follow best practice. This ensures a balanced and defensible valuation. Below are some common mistakes in practice which can affect a valuation outcome:

1. Using ‘customary’ or ‘typical’ industry multiples

Many valuers to this day use ‘rules of thumb’ based on certain industry averages to determine a business’ earnings multiple, particularly in industries which have a long transactional / acquisition history. Approaching the valuation in this manner means you may ignore several important characteristics of the business such as its geographical location, cash flow, it’s competitors (e.g. Five Forces & PESTEL analysis) and its particular operating results.

Rather than using a rule of thumb, it is important to assess different types of comparable data (i.e. recent sales) to determine appropriate proxies for the business being sold.

2. Inappropriate valuation models

There are three principal valuation methods, being:

  1. Income Based (i.e. Discounted Cash Flow methods);
  2. Market Based (i.e. Capitalisation of Earnings methods);
  3. Asset Based (i.e. the fair market value of the businesses’ net assets)

Certain valuation methods will be appropriate for certain businesses. A market based valuation such as Capitalisation of Earnings method effectively assumes there will be stability in the level of profitability and growth rate of a business, where as the discounted cash flow method allows more ‘tweaking’ of expected income as it involves calculating the net present value (NPV) of future cash flows.

Which ever valuation model is used it is important to consider aspects of the business which may not be immediately apparent from the raw numbers, such as the specific risks the business faces, non-operating assets held by the business, and “off balance sheet” liabilities.

3. Insufficiently normalising EBITDA

Earnings before interest, taxation, depreciation and amortisation (EBITDA) is the main number upon which a market-based valuation will be predicated. In order for the historical and forecast EBITDA to be reliable from a valuation perspective, it must be ‘normalised’.

‘Normalisation’ is the exercise of removing all ‘extraordinary’ (i.e. unique or one-time) transactions which are not an ordinary and recurring revenue (or cost) of the business. From a revenue perspective this could involve income from the sale of a division, government rebates and grants, or the sale of other assets such as business property. Extraordinary costs may be expenditures such as Research & Development (R&D), Business Development, or other one off outgoings such as legal settlements.

4. Unrealistic Forecasts

Oftentimes, businesses can forecast EBITDA which is more optimistic than may be realistic. This is due to ‘recency bias’. What is recency bias:

“Recency bias” is the phenomenon of a person most easily remembering something that has happened recently, compared to remembering something that may have occurred a while back.

If a business has undertaken a valuation on the back of a recent upswing in its performance, the growth figures used in its forecast EBITDA may be unreasonably generous. In order to avoid this occurring it is important to consider characteristics unique to the business such as:

  • What is the existing market share (and has a market analysis been undertaken);
  • Who are competitors in the industry;
  • What is the relative power of buyers and suppliers;
  • What is the threat of substitution (i.e. threats that buyers will find an alternative to the businesses brand)
  • Threat of new entrants (i.e. new businesses threatening market share)
  • What is the businesses growth strategy?

5. Failing to ‘back up’ your Primary Valuation method

In order to support the calculation of a businesses’ value, a report should always contain a secondary valuation of the business (using an alternate method) in order to provide credibility to the primary valuation. For example an NPV Discounted Cash Flows approach to the valuation could be backed up by a Capitalisation of Earnings approach.

An earnings multiple can be determined under the latter valuation approach, which may then support the calculation of the Enterprise Value (EV) under the original DCF approach.

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