Behind The Curtain – Understanding Bias in Valuation Reports©

Part III, Is Business Valuation an Art, Science or Craft?

By David Goodman MBA, CPA/ABV/CFF, CVA and Les Gosule, MST, CPA/PFS, CVA

“Art and science have their meeting point in method.” Robert Bulwer-Lytton (English statesman and poet)

Valuing a closely-held business combines elements of art and science. Some like to call business valuation a craft which applies art and science. Science is the state of knowing: knowledge, as distinguished from ignorance or misunderstanding.

Such principles clearly apply to techniques commonly used in valuing businesses, such as financial analysis in which we compare various financial indicators for a business over time and to its industry peers. These principles also apply to our valuation methodology such as when we use discounted cash-flow analysis. (The discounted cash-flow analysis method uses an interest rate to value a stream of cash over time; the farther out in time the cash accrues, the less it is worth in present-value terms.)

Art, on the other hand, is defined as a skill acquired by experience, study, and the conscious use of skill and creative imagination. The art in a business valuation is how one applies professional judgment. It also involves the use of creativity to solve problems. While creativity can be helpful when valuing; it’s inappropriate when it’s used to support a preconceived result.

Just as “too much” art can undermine the objectivity of a business valuation, false science can, too. One element of this is attempting to be too precise. The art of valuation requires professional judgment and reasonable experts may reach different conclusions. For any given enterprise there is a range of values for the business. All valuations are based on an expectation of future worth and the future is unknown. Within a business valuation there are many places were professional judgment must be exercised and for which there is a range of appropriate responses.

For example, a common valuation methodology is the capitalization of earnings. This involves dividing a single period cash flow by a capitalization rate. In determining the capitalization rate, the valuation analyst may need to determine a company specific risk premium and a long-term growth rate. These require the use of professional judgment. Unless one is valuing a very large company, is a capitalization rate of 20.43% more meaningful than a capitalization rate of 20.4%?

Another area in applying the capitalization of earnings method is how the valuation analyst weights the historical cash flows. Let’s take an example. Our analysis results in the following cash flows:

How should they be weighted? Should a straight average be used? Should a weighted average in which the most recent years are given the most weight be used? Should only the most recent year be used? Based on his/her understanding of what lies behind the numbers, the valuation analyst must use his/her professional judgment to decide. An expert looking to bias their answer may use a weighting that does not make sense.

In many ways business valuation is a young field struggling to develop a theoretical framework that is built on scientific knowledge. However, if, as one valuation analyst put it, we had a theoretical model that was really good at making predictions, we would be making lots of money in the market and not performing business valuations. So while our valuation work will be built on our observations; it is our conclusions drawn from our understanding of the business and industry, and our use of professional judgment that we have to rely on.

In Part IV of this series will be a Review of Basic Concepts

Gosule, Butkus & Jesson, LLP is a full service accounting firm with extensive experience in performing business valuations in a variety of industries including construction, service, restaurants and dental practices. We serve the greater Boston area and New England. For more information, please see our website at www.GBJ-BestCPA.com.

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