Posted by Jonathan A. Patterson, CPA, CVA
Whether you are considering a business sale, merger, or acquisition or need to understand an organization’s value for another reason, such as estate planning or gifting, determining an accurate value will help you make smart decisions. Because of the many potential variables regarding a company, and even different methods that may be used to value a business, there are common pitfalls that may affect the valuation. To help our clients and others understand – and avoid – these pitfalls, Belfint, Lyons & Shuman has provided a summary below based on the most commonly accepted business valuation approaches.
Market Approach Pitfalls
The market approach utilizes actual transaction data from the sale of similar companies to help determine a company’s value. Some data that may be evaluated include the operating financial metrics of similar companies still on the market, private company transactions, public company transactions, and even valuation measures using current stock market data for public companies.
When applying this approach, common pitfalls that could cause an inaccurate business valuation include:
- Selecting peers that do not accurately compare to the company in financial, operational, or other terms
- Using incorrect financial ratios to perform your analysis
- Not considering the impact of non-core operations, non-operating assets or abnormal historical events in the earnings base
- Ignoring the impact of ownership interest (i.e. not considering whether the interest you’re valuing is controlling or non-controlling, etc.)
Cost Approach Pitfalls
This approach is also referred to as the “asset-based approach,” where the value of the business is determined by the total market value of the company’s tangible and intangible assets and liabilities. Tangible assets include things such as equipment and inventory, which are often easier to value than intangible assets, which include factors such as a loyal customer base and brand awareness.
Under this approach, an appraiser makes adjustments to the value of the assets to account for market value changes. Common errors to avoid include:
- Failure to utilize outside experts to accurately value certain assets
- Working with a scarcity of information (i.e., real estate and profession to value real estate)
- Failing to make adjustments for assets that are not easily sold or for which there is no active market
- Failing to consider operating and transaction costs that may be incurred prior to the planned sale or liquidation of the asset
- Failing to consider special ownership issues (restricted, partial, etc.) or other factors that may limit the company’s title to particular assets
- Failing to consider the tax impact of a sale (i.e., any unrealized gains or losses)
Income Approach Pitfalls
The income approach focuses on current earnings and past financial indicators to predict the ability of the company to earn future income.
For this approach, some common pitfalls to avoid include:
- Using rates of return or capitalization rates that do not account for the company’s specific risk profile based on its financial and operational metrics
- Failure to normalize the earnings base under consideration, especially in the context of future (or “residual”) periods
- Incorrect working capital assessment of needs, especially as related to future growth or operations
- Mismatch of long-term capital expenditures and related depreciation expense, especially as related to future periods
Conducting a business valuation is not a simple process. There are a number of different variables that should be considered when selecting the proper approach.
If you need a business valuation conducted or have questions, the Valuation Team at Belfint, Lyons & Shuman wants to help! For additional information please contact us at 302.225.0600, or click here to contact us. We look forward to speaking with you soon.