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Common Valuation Errors

Hi all, I am interested to see what, if any, errors or problems people commonly see with business valuations, either theoretical or empirical. 

One of the most common errors I see is the double-counting in the assessment of risk, which is often reflected in the cap rate (WACC) and in the application of discounts.  The most common discounts, such as marketability and minority interest, are usually taken after the fact, however more subjective discounts, such as key person, small company or lack of diversification, most often are reflected in the cap rate.  Sometimes, however, these risk factors can be incorporated in a summation (which should actually be multiplicative) of discounts as well as the cap rate in the valuation conclusion.  Clients should be careful to recognize this.

I welcome any other thoughts and hope this discussion is helpful.

Answers

Topic Expert
John Kogan
Title: CEO/CFO
Company: Proformative, Inc.
(CEO/CFO, Proformative, Inc.) |
Randy: I have done a lot of valuations in my day as CFO and I find the whole process fraught with peril for private companies (I will not address public companies). The problem in general for private companies is that most of the "industry standard" discounts are averages which a)may have nothing to do with your company and which are wrong for your company roughly 100% of the time and b)they are not placed meaningfully in time. That is, those averages are not reflective of today's financial environment but rather are a measure of past environments. I guarantee you that the market would apply a different discount today than they would on the exact same business two years ago, but the averages are only averages and they tend to reflect history, not current events. Next up, the methods of valuation. Comps/multiples and DCF modeling are both popular and both hugely flawed for all but the most established companies. Unless you are in an industry where there are a lot of private company exits and their numbers are readily available (this does not describe many industries) it is very hard to find true comps. You can rationalize your way into many comparisons but at the end of the day your buyer determines your price based on their thoughts on your value unless you have multiple bidders. I have worked for a number of very large public companies and their margin of error on current year budgeting, much less 3 or 5 year forecasts, is very large. And these were companies with unlimited budgets and the most sophisticated modeling tools you can find. For private companies, which tend to be smaller, it is truly a crapshoot. So DCF, even before we talk about discount rates, is highly subjective with high variance. So what does it all mean? Simply that valuations are more art than science and that there is no right answer. There is, however, supply and demand, and that determines real market value. But until you are in a sales mode with one or more viable buyers, anything you model will be just numbers on the page. I find the most valuable aspect of the process is the process itself. I know I will never come out with the "real" number a year or three out, but it invariably teaches me things about the company and its economics - which is very valuable indeed.
Peter Lyons, MBA, CMA
Title: Finance and Technology Enthusiast
Company: Currently Looking
(Finance and Technology Enthusiast, Currently Looking) |
One of the ways that we hedge the margin-of-error is by running a simulation similar to that of a projected hurricane path where you have the forward looking cone that gets wider and wider as the landfall date is further out. We apply a similar type of strategy by running our DCF based on three different scenarious (downside, base, upside). We allow the the DCF to run it's course and supply us with the outputs and then we argue around the weighting of the various cases.
Topic Expert
Randy Lewis
Title: Managing Partner
Company: LP Valuation, LLC
(Managing Partner, LP Valuation, LLC) |
Yes, there certainly are many subjective issues and I totally agree that valuation is both art and science. All we can hope for is to get the "science" part as fundamentally sound as possible. Since valuation is such a permeating theme in the business and regulatory environments. we have to have some way to do it! In plain terms, "value" is the highest price a purchaser is willing to pay - which we never know until after the fact. All we can do is estimate.
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