Five Common Errors in Business Valuation Reports

As a business owner, you may need a business valuation for any number of reasons. The result of a business valuation is typically communicated in a formal written report, which documents how the valuation analyst arrived at the business’ economic value. Additionally, business valuation reports provide key insights regarding the nature of a company’s operations, its strengths and weaknesses, risks and opportunities, industry and economic trends, and other relevant factors. This analytical depth can result in business valuation reports ranging between 80 and 120 pages long—which may be overwhelming for the reader. Yet, with so much riding on these reports, it’s important to understand the ultimate work product, so that you can feel confident in your expert’s valuation conclusion. Keep an eye out for these five common errors, so that your business valuation remains a reliable resource for you and your team.

1.  Math Errors

When reviewing a business valuation, the first important piece is to check the preparer’s math. The report could otherwise be flawless, but a math error that results in significantly overstating or understating the company’s value could be catastrophic for that expert’s opinion. Math errors can have a bigger impact than one may think, as errors made early in the valuation process can upset assumptions made later on. If errors are found in the valuation report, it is worthwhile to recalculate the values and reanalyze previous assumptions considering the corrected information. It is also worth investigating as to whether the expert made mistakes elsewhere in your report.

2.  Applying the Asset-Based Approach Without Considering Intangible Value

The asset-based approach usually starts with book value and then converts all assets and liabilities to their fair market value. A common report error arises when the valuation analyst includes values for the company’s tangible assets (e.g., cash, accounts receivable, fixed assets, etc.), but doesn’t perform any analysis to estimate the value of intangible assets. When prepared correctly, the asset-based approach should always include values for the company’s intangible assets or goodwill—to the extent there is any. Nevertheless, the process of measuring the intangible assets can be very complicated and for most operating businesses, the income and market approaches are a more efficient way to capture both the tangible and intangible value of the company, so the asset-based approach is often not utilized.

3.  Applying Both the CCF and DCF Methods Under the Income Approach

Another common report error occurs when the valuation analyst applies both the capitalized cash flow (CCF) and discounted cash flow (DCF) methods under the income approach, and then weights the results to form a single indication of value. However, as these methods are mathematically interrelated—the CCF is an algebraic simplification of its more detailed DCF counterpart—they are exclusive of one another; meaning the valuation analyst should apply either the CCF or DCF method, not both. Deciding which income approach method to use depends on the facts and circumstances including but not limited to, whether the business is in a mature or growing business cycle, if budgets or projections are prepared in the normal course of business, and whether the business’ historical performance provides a reasonable indication of the future. Regardless of which method under the income approach is applied, the business valuation report should always discuss the reasons why one method was deemed superior to the other.

4.  Overreliance on Rules of Thumb

Using a rule of thumb to value a company is a simplified form of the market approach, in which an industry-specific multiple is applied to the subject company’s revenues or earnings to obtain the estimated value of the business. For example, average full-service restaurants may sell for 30 to 40 percent of annual sales, or typical dental practices sell for 2 to 4 times EBITDA. These multiples are considered “pricing tips” by business brokers and can be found in various publications and journals. While easy to apply, rules of thumb are generally too broad to be of much use in valuing a company, and there is no agreed-upon definition for the financial measures used. Moreover, rules of thumb are seldom, if ever, used as the sole means of valuing a business, as so many other factors (e.g., customer base, cost structures, location, local competition, debt, cash flow, etc.) need to be considered.

5.  Lack of Support for the ‘Why’

Many business valuation reports include a general lack of support for subjective factors, or the analysis is only a mere regurgitation of facts with no discussion of ‘why.’ For instance, if a company’s revenue increased at a five-year compound annual growth rate of 10 percent, a thorough report would discuss the factors driving this growth. Did the company release a new product? Hire more sales personnel? Open a new location? Acquire a significant new customer? Increase prices? Moreover, if revenue growth is expected to continue for the foreseeable future, the reasons for this continued growth should be stated.

A detailed business valuation report should tell the story of the business and explain the valuation professional’s thought process while analyzing the business, so that the reader has confidence in the conclusion of value. If that isn’t done properly, the conclusion of value is not very convincing. No matter how ‘correct’ the conclusion of value is, it may not be accepted by a trier of fact if the valuation expert does not provide sufficient details and explanation about how they arrived at that conclusion.

Helping You Get There…

There are numerous other errors that must be carefully avoided in business valuation reports, including: