subject: Five Mistakes With Business Values [print this page] Many people buy and sell privately held businesses and professional practices with the dream of being independently wealthy. One bad choice can turn this dream into a nightmare. By pointing out some common errors found in business valuation reports, I hope to give you, the reader, some tools to critically review the value and call attention to errors when you see them.
First is the basis for discount rates or capitalization rates. These rates are company specific and apply to the specific valuation date. They are based on rates available in the market and the company's specific risk factors. If risk factors for the specific company change or the rates in the market change, the company's rate will also change. The appraiser needs to explain how he or she calculated the rate along with the sources used. The reader should be able to understand these rates by researching the information referenced within the report. An "industry standard" rate should be questioned. One rate used for a whole industry is erroneous.
Second is the search for comparables. Companies used as sales comparables need to be similar to the subject company. If the companies selected by the appraiser are vastly different, the value conclusion will not be applicable. Comparing a local privately owned retailer to Wal-Mart is like comparing a small row boat to an aircraft carrier. Sure they're both boats but that's where the similarities end. Another area to watch is the selection of comparables within transaction databases. The appraiser should not cherry pick the transactions to get an inflated or depressed value. The data needs to be selected on an objective basis. Explanations should be given as to why any transaction was left out of the analysis.
Third is the growth rate. This rate needs to be supported by objective factors specific to the business. Reports containing growth rates with little to no explanation of how they were calculated should be questioned. The rate used usually has a material impact on the company's value.
Fourth is the long-term sustainable growth rate. If an appraiser projects a long-term growth rate for the company at, let's say, 15 percent. He or she is implying that the business will eventually take over the world economy.
Fifth is the basis for the forecast assumptions. These assumptions need to be supported by the facts within the appraisal report. If the economy and industry are expected to contract in the near future and the company's revenue has declined 10 percent each year for the past five years, forecasting a 20 percent revenue growth rate for the next year is not realistic.
Although not always the case, management forecasts are typically doomsday forecasts when the owner is going through a shareholder dispute and overly optimistic when it is time to sell the business. Appraisers should explain all their forecast assumptions in the report. They should be supported with unbiased factors in the economy and industry. The reader shouldn't take any forecast at face value. If the forecast is not explained clearly, the user of the appraisal should get a second opinion.
by: Joseph Phelon
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