Common Errors in Business Valuations

common errors in business valuations

The value is what the value is. The charge to the valuation analyst is to develop a conclusion or calculation of value. The result should be unbiased. There are dangers all around the analyst and the respective assignments. However, the analyst must address each of those and deliver, to the best of his or her ability, an unbiased, supportable, conclusion or calculation.

I deal with this subject in the book that I am writing, tentatively titled, “Introduction to Business Valuation for Matrimonial Lawyers.” The subject is referred to as common errors in business valuations. Those errors can result from many things unintentional or intentional. In this article, I want to provide a summary of the most common errors valuation analysts obverse.

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Benefit stream.

The benefit stream is the valuator’s determination of expected earnings or cash flow of the subject company into the future. Is the expected future benefit stream reasonable? Do you think this company could produce that level of earnings or cash flow into the future? How did the valuator handle trends? What did she do with more or less profitable years? The conclusions reached and responses to some of these questions are where some reports result in simply illogical or unsupportable results given the historical data.

Normalization adjustments.

This is a significant area in the development of the value and fertile ground for errors to occur. Readers and users of reports should pay attention to or watch out for inconsistencies in the adjustments, or perhaps adjustments all going in one direction or the other, making earnings/cash flows higher or lower. Additionally, beware of adjustments that seem to contradict other portions of the report. For example, and of great significance in matrimonial litigation, if the officer and/or owner is assumed to be in the top 1% in the industry, you should expect their compensation to trend the same way, in the top percentile. Further, the significance of getting officer compensation right is even more important when considering the ‘double dipping’ principle.

Company specific risk premium.

This premium is a part of the larger commonly known discount rate. The selection of an appropriate premium is based on data and analysis of the subject company, in addition to judgement from the valuation analyst. It has been said that business valuation is an art and a science. This is an area where there is more art than others. Fortunately, and thankfully, through the dedication of many in this field, there is now more science to it than ever before.

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Failure to reconcile approaches.

Another possible error in valuations includes the failure to reconcile the approaches. Ideally, the different approaches should result in similar values, at least for the income and market approaches. If the analyst provides the values from two different approaches, and the results are vastly different, there is either an error or a plausible reason for the difference. For example, assume the income approach and market approaches produce values of $500,000 and $1,500,000, respectively. These values, as is, most likely should not be averaged together to produce a $1,000,000 value. Instead, the analyst should investigate each for potential errors in the development of their approaches.

To be clear, there are more areas for error. These are just a few common areas I have observed personally or in conversations with other analysts. The report that the analyst prepares and conclusions reached should be logical. If you find yourself reading a report and are surprised or feel like a conclusion of value is not consistent with the narrative and information provided, raise your hand. There could be a very good reason for it, or it could be an error.

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