As a continuation of this four-part series, there are four key issues that must be considered when performing valuations on business entities. Ignoring them (or confusing them) can make a valuation analysis less reliable, or in the worst case, just downright wrong.
Issues previously discussed were (1) basis of value and (2) selecting relevant financial components. In this part, we’ll discuss the third issue to consider: common errors to avoid. For business valuations, an appraiser will typically consider the three commonly accepted approaches: Asset Approach, Market Approach, and Income Approach.
The Asset Approach focuses on the value of the assets held by the business (whether tangible or intangible) to determine the value of the business. The Market Approach focuses on transactions of similar companies or the operating metrics of other similar companies in the market from which one can determine an indicated value of the subject business. The Income Approach focuses on the ability of the subject company to produce income.
The first common error can occur if an inexperienced appraiser fails to consider any of the three approaches. Careful consideration of the facts and circumstances related to the subject company can help guide an appraiser’s determination of the applicability of the approaches; however, he or she must consider them all.
Under the Asset Approach, an appraiser makes adjustments to the value of the assets to account for the market value of the underlying assets. Some common errors to avoid when applying the Asset Approach include:
- Information Scarcity – Is accurate real estate and other asset appraisal information available? Is it appropriate?
- Asset Quality – Are the assets readily salable? If they are financial assets, are there ready buyers?
- Cost Considerations – What are the operating and transaction costs that may be incurred until a planned sale or liquidation of the asset?
- Ownership Considerations – Are any special ownership issues (restricted, partial, etc.) or other issues that may limit the subject company’s title to the asset?
- Tax Treatment – Are there any unrealized gains or losses that should be considered?
Under the Market Approach, an appraiser looks to market values of similar companies in the market (either by way of a transaction or from readily-available financial information) in order to derive a value of the subject company. When applying the Market Approach, some common pitfalls to avoid include:
- Comparability – Selected peers do not match the subject company in financial, operational, or other terms
- Ratio Comparison – Comparison periods do not match; incorrect comparison without consideration of qualitative and/or quantitative differences
- Non-Core Operations – Including the impact of non-operating assets or abnormal historical events in earnings base
- Ownership Interest – Ignoring differences between public company peers (typically at a minority interest level) and the subject company (typically a private company with a controlling interest level)
Under the Income Approach, the ability of the subject company to produce income is what an appraiser considers in order to derive a value of the subject company. For the Income Approach, some common pitfalls to avoid include:
- Identifying Risk – Errors in deriving applicable rates of return or capitalization rates
- Normalization – Failure to normalize the earnings base under consideration, especially in the context of future (or “residual”) periods
- Working Capital – Incorrect working capital assessment of needs (especially as related to future growth or operations)
- Capital Expenditures – Mismatch of long-term capital expenditures and related depreciation expense (especially as related to the future periods)
In conclusion, when performing a business valuation, an appraiser should consider the three common valuation approaches: Asset, Market, and Income. Avoiding the common errors in those three approaches are key to providing reasonable, supportable conclusions in a business valuation. In a future post, we’ll explore the remaining one key issue that is essential to performing reliable and appropriate valuations. In the meantime, if you have any questions about avoiding common errors in your valuation assignments, please contact either Dan Branch at 770-635-1582 or Mary Varon at 770-635-1569. How can we help?
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