Everyday companies large and small, public or private are the subject of Business Valuation procedures. Despite major advancements in valuation literature and developed educational pathways which enable practitioners to ‘upskill’, I am still amazed by the number of mistakes made when undertaking engagements of this nature.
The following are three of my favourite tips for avoiding these errors when valuing your business:
1) Future Maintainable Earnings (“FME”) and the ‘Average of 3’
When applying an Income Approach and more specifically the capitalisation of FME methodology, it is common for the FME to be calculated by averaging the earnings achieved over the past three financial years. This practice is inherently flawed and at odds with the concept of FME which requires a forward looking, not retrospective approach to assessing earnings.
Errors in the averaging of historical results are magnified during periods where wages, rent or other material costs are rapidly increasing. Additionally, recent changes such as relocations to larger (and more expensive) premises or an expanded workforce are not appropriately captured. Pricing changes and any departure from historical gross margins are also overlooked in the averaging process.
With so much time spent labouring over the earnings multiple, it is a shame the determination of FME does not warrant 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 appear unstoppable. From a valuation context it is important to be aware of external factors which impact the key drivers of the subject business.
Research house IBISWorld publishes their views on industries set to ‘fly and fall’. History is clearly a poor guide when valuing businesses at either end of the spectrum. In 2015 a suggested underperformer are those involved in the manufacture of mining and construction machinery. News agencies and video stores have been named in previous years. Outperformers include online groceries and hydroponic crop farming. A deep understanding of the industry can help avoid unrealistic valuation conclusions.
3) Failure to Crosscheck
The Valuation practice is a highly subjective discipline and it is rare to get absolute agreement between practitioners. Despite this, the process of cross checking conclusions is paramount in confirming or rejecting any assertions made. It may serve to tighten a valuation range, dismiss erroneous conclusions and ensure that outputs have regard to the ‘real world’.
Crosschecks should include alternate methodologies to validate or discredit the primary approach. Further, conclusions based on theoretical inputs such as betas, alphas and bond rates should be measured against economic and industry expectations to ensure conclusions are not too divergent. If a chicken looks like a duck and sounds like a duck, it may in fact be a duck! In other words, if the valuation scope requires an assessment of fair market value, does the outcome represent a value that would be acceptable to the market?
The subjective nature of business valuations requires practitioners to move away from ‘autopilot’ and rigorously challenge the methodology, the inputs and especially the outputs prior to going to print. There are currently only 98 CAANZ accredited Business Valuation Specialists across Australia and New Zealand. Contact one from our team who can work with you to navigate valuation complexities and provide deliverables that are fit for purpose.