The Four Things to Watch for in Business Values
A lot of people rely on the value in an appraisal report when they buy or sell a business or professional practice
. In this article, I would like to point out four areas in appraisal reports where errors tend to arise. I hope to give you, the reader, some tools to assess an appraiser's value.First is a numbers only appraisal. This type of report has little to no analysis, explanations, or conclusions. The appraiser assumes the reader will not question him and will just trust him on the facts. This type of report is typically written by someone who lacks appraisal education and training. A numbers only appraisal may also indicate the appraiser has a personal agenda or bias to one of the parties involved in the transaction. The objective facts don't support the reported value that is why the writer simply leaves them out.Second is a rule-of-thumb appraisal. These reports are similar to a numbers only appraisal. The values typically come from a percentage or multiple of revenue or earnings without any thought. The appraiser does not explain why the value is correct for the subject company.Here is an example of what I mean. Suppose you had the choice to invest in one of two businesses. Each on had $1 million in annual revenue last year. The rule-of thumb for the industry is, let's say, 2 times revenue. Both companies are worth $2 million dollars right? The first company had an annual revenue growth rate of 5 percent a year for the past five years and a profit margin of 10 percent. The second company had annual revenue decline at a 10 percent rate each year for the past five years and an operating loss of 10 percent. The first company has new equipment. The second company has old equipment. If you relied on the rule-of-thumb, you would pay the same amount for either company. Do you really think these companies are worth the same amount of money? So how much more do you think the first company is worth? Is it worth 10% more? How about 100% more? How much less is the second company worth? Is it worth 10% less? How about 90% less?Precision vs. accuracy is the third area. Appraisal values can be accurate; however, they are not precise. Be skeptical of values showing precision. If an appraiser's opinion of value goes to the last penny for example $14,289,809.64, he or she is misleading the reader.The fourth area to watch for has to do with the normalizing adjustments. Normalizing adjustments are used to place the company's financial information on an economic basis. These adjustments give the appraiser and the reader of the report a better understanding of what prior operations would have looked like under normal conditions. Things like floods or fires are taken out because they are one time events that had an effect on the company's operations, but they are not expected to happen again.Someone wanting to artificially inflate or deflate the company's value can easily do so with these normalization adjustments. All adjustments should include detailed explanations. These explanations should tell the reader why they were adjusted. The adjusted amounts need to be supported by objective data. At times, adjustments are not explained or supported by the facts. If this is the case, they should be questioned.The Four Things to Watch for in Business Values
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