Elements to Avoid When Valuating a Business - VR Business Sales Blog

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Wednesday, November 30, 2011

Elements to Avoid When Valuating a Business

Peter King
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When valuating a business, it's important to understand the common mistakes that can be made. At VR, we perform a business valuation that is not only comprehensive but avoids relying on certain elements such as the following.
 
Unrealistic Cash Flow Projections 
The most common mistake typically made in valuation is unrealistic cash flow projections vs. the discount rate being used in the discounted future cash flow analysis. Aggressive growth projections, when not well supported by good market research and analysis of the company being valued, carry high risk factors with them. This should prompt an increase in the discount rate (required rate return) used. 
 
Use of Earnings Multiple 
Another common mistake is using a “fixed” discount rate or capitalization rate with many different earnings streams. As the earnings base increases (net income up to pre-tax income up to EBIT up to EBITDA etc.), so should the discount rate or capitalization rate.
 
Use of EBITDA 
The use of EBITDA can sometimes be dangerous due to the above-average-projected working capital or capital expenditure requirements. Cash is king and a discounted free cash flow analysis should always be performed. 
 
Any projection that eliminates taxes, depreciation and amortization is essentially a short-term projection. Eventually, the qualified buyer’s business will pay taxes, and it will have to replace depreciated tangible property and amortized intangible property.
 
Reliance on Comparable Companies 
Many buyers, sellers and outside business brokers will rely solely in comparable sales. The problem seen in relying on this method is that no two companies are alike in both financial and operational structures. The use of the “market method” or “comparable company method” can only be used effectively if the comparable research is thorough and done correctly. This will assure that the companies being used as a comparison are, in fact, similar in structure to the company being valued.
 
Unrealistic Earnings Adjustments 
The final common mistake in estimating the value of a mid-market company is the abuse of “add-backs” or adjustments to the earnings stream. The two most common adjustments are non-recurring income or expense and officer salary adjustment. Many sellers look to add back actual business expenses and leave non-recurring income, when, in fact, it should be the other way around. 
 
Many sellers of mid-market companies tend to adjust officer salary to below industry averages. When adjusting the officer salary, it is not what a new replacement officer will want it is what is fair based on the responsibilities of that officer and what other officers in similar positions are being paid. The question should be asked, would you take a $50,000 annual salary to run a $10 million company?  Probably not.
 
Try placing yourself in your counterpart’s shoes and switch roles when valuing the company you’re selling (or buying). Research, facts, and analysis should be the foundation of the valuation and before making an assumption of the valuation and before making an assumption in your analysis ask yourself if you would make that assumption if you were on the other side. Taking this approach will certainly point you in the right direction and more than likely will take some time off your negotiations too.

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