Part VI, The Grey Areas of Business Valuation

I like to play the grey areas in life - that's the most uncomfortable place to be.—Melanie Lynsky

In theory there is no difference between theory and practice. In practice there is. – Yogi Berra

So now you have a valuation report prepared by an expert. How do you go about reading it? The first step is identifying where the valuation analyst has exercised their professional judgment and understanding how the valuation analyst supports their decisions.

When a valuation analyst uses the asset approach to value a business, the value of the underlying assets and liabilities must be determined. What methods does the appraiser use to value assets and are these methods consistent with the applicable standard of value? For example, if real estate is being valued, did the appraiser value the property in its current use or highest and best use? If the valuation is for a Massachusetts divorce, highest and best use may not be appropriate.

The treatment of accounts receivable and inventory, can significantly affect the valuation of a retailer or wholesaler. In a marital dissolution, an appraiser working for the buyer might write off more receivables, and write down more inventory, than one engaged by the non-business owning spouse. An appraiser looking to devalue an asset may use a “fire sale” liquidation value rather than an orderly liquidation value.

If the adjusted net book value (also known as the adjusted net asset value) is used, this results in a control, nonmarketable value. Some business appraisers believe that this is also a marketable value because all of the underlying assets can be realized at their stated values at any time by the owner.

In applying the market approach, a key subjective consideration is what constitutes a “comparable” company. Obviously, no two companies are identical, so the outcome may depend on what criteria are selected as bases of comparison. The valuation analyst must choose what multiples are most appropriate: price to earnings, price to sales, or some other ratio. If a combination of ratios is used, how are the various quotients weighted? Critical in this process is what statistical measure, (average, median, harmonic mean, regression) is used to estimate the market. Depending on the data, the statistical measure can give very different results.

Under the income approach there are numerous places when professional judgment is needed. One such issue is what constitutes “reasonable” compensation for the owner, the more that is paid in salary and benefits, the less remains to be treated as “income” to the business and the lower the value of the business.

Another is the choice of the discount rate for valuing future earnings. If the appraiser uses the “build-up” method to determine the discount rate; did they double count risks factors? For example, did the appraiser use a size premium? What size premium was used? Depending on the size premium used this may include risks that the appraiser also addresses if adding an additional company specific risk premium.

Also look at what future growth rate the appraiser used. The reviewer must ask does the growth rate make sense for the type of company, the economic conditions, the rate of technological innovation, competition, and so forth. Growth is dependent on many factors unique to a business. When looking at the capitalization of earnings method for example, the growth rate is the growth rate into perpetuity. As one attorney once pointed out …”that’s a really long time.” Keep in mind that the higher the growth rate, the higher the value of the business and the lower the growth rate, the lower the value of the business. Another aspect of growth is a business cannot grow without reinvesting some portion of its earnings… whether this be to pay for capital expenditures, additional space, or working capital to support additional employees.

All of these areas provide an opportunity for an appraiser to build bias into their result. The better job an appraiser does explaining why they made the decisions they made; the less likely the appraiser can hide any biases.

In Part VII of this series, we will discuss Identifying Bias in a Business Valuation.

Gosule, Butkus & Jesson, LLP is a full service accounting firm serving Greater Boston, Massachusetts & New England, with extensive experience in performing business valuations in a variety of industries including construction, service, restaurants and dental practices. For more information, please see our website at www.GBJ-BestCPA.com. Also, please contact us if you would like us to do a presentation to your firm or clients on drivers of business value.