September 1, 2014

Shades of grey in business valuations

What do you get when you put two equally qualified and experienced Chartered Accountants in a room with a set of financial statements for a successful and profitable business, ask them to prepare a valuation of that business and lock the door for two days?

Well provided they don’t kill each other out of boredom, many of you may expect the resulting valuations to be very similar in approach, methodology and the final outcomes. You will more likely than not find two very different valuation reports, with possibly very different findings in terms of the dollar value for the business.

When there is a meeting of experts as a result of two accountants attempting to value the same business, or being cross-examined in the witness box, it is not the mechanical aspects of a valuation that is being argued about, it tends to be the finer subtleties and nuances where professional opinion comes into play.

The areas where the expert’s professional opinion comes into play include:

  • Which methodology to use
  • What discount or capitalisation rates are appropriate
  • When minority interests exist
  • When different classes of shares exist
  • When false and/or misleading financial records are provided.

The most common methodologies used to value a small to medium sized business are:

  • Discounting future cash flows
  • Capitalising future maintainable earnings
  • Asset based valuations

The first two methodologies are income based and are appropriate when the business is a going concern and is profitable, while an asset based methodology is typically used when a business is not profitable or is not likely to continue into the future.

When using the discounted cash flow methodology, we need an appropriate discount rate to restate the future cash flows of the business back to a single figure as at the date of valuation. Similarly, when using the capitalised future maintainable earnings methodology, an appropriate capitalisation rate is required.

These rates can be a very real area of dispute between opposing valuers. Recently, SV Partners had a case in which a business was valued using the future maintainable earnings methodology, with a capitalisation rate of 40%. This capitalisation rate was arrived at by starting at the risk free rate of return, then adding a premium for both equity and size, and finally identifying a number of components of specific risks to that particular business. In our report, we explained in depth over 11 paragraphs how we came up with these components.

In this particular case, the opposing expert arrived at an amount of twice that of our value, with a discount rate of 20% which, in our opinion, greatly over valued the business. The only commentary found in the opposing expert’s report to justify this discount rate was:

“I have used a discount rate of 20%”

The existence of minority interest holdings can also be a source of dispute between expert valuers. In another recent case, SV Partners was engaged to value the interest of the majority shareholder of a very large privately held company. The opposing expert had discounted the holding by 16.7%. We found this excessive as that major shareholder while not having total control held over 71% of the voting shares of the company, and had effective control.

Businesses are often valued by ‘rules of thumb’. These methods are often used by business brokers, and while sometimes actual sales in the market of businesses are based on these rules, they invariably do not reflect the true value of the business. Typically, these rules rely on multiplying gross revenue by a particular multiple, and pay very little if any attention to expenses of the business and its underlying profitability. These methodologies are to be viewed with a great deal of scepticism.

There are many instances where the financial reports of a business to be valued paint a picture that is in reality far from the truth. Many of these financial records contain the following:

  • Unrecorded income
  • Overstated expenses
  • Expenses and incoming appearing in the wrong entities
  • Siphoning off of cash

As you can see, there is a great deal of scope for the variance in professional opinion to have a significant effect in the valuation of a business. In the ordinary course of events, an accountant valuing a business would accept the financial statements on face value unless suspicions were raised to the contrary. In these situations, there may be a need for more than just a straight valuation but a full forensic investigation to be conducted.

SV Partners’ provides our clients with an objective and defensible opinion of the value of their organisation. Our valuations combine expertise with leading valuation and corporate finance knowledge. If you would like some assistance with your business valuations, please contact one of our expert advisors on 1800 246 801.

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