Debunking Four of the Most Common Misconceptions About Business Valuations
When a business owner retains the services of a business valuator, they often enter the process with several misconceptions about the nature of business valuations and the work of business valuators. Some of the more common misconceptions include:
1. Value vs Price
Often people will use these terms interchangeably. However, they may have very different meanings and figures associated with them.
The value of a business is determined through careful analysis, by an experienced valuation professional, considering numerous factors regarding the nature and characteristics of the business, as well as the industry and economy in which it operates. The valuator will consider a number of valuation approaches in order to arrive at a valuation conclusion that will provide a notional investor with a reasonable return on investment, given the risks of the business. This is often referred to as a ‘notional’ valuation.
The price of a business may be higher or lower than the value indicated by a notional valuation. Some of the factors influencing price include different purchaser vs vendor negotiating strengths, different risk assessments, structure of the transaction, synergies, and non-economic considerations. These factors and the price of a business can only be determined with any degree of certainty when a business is exposed for sale in the open market.
2. Rules of Thumb
When trying to determine the value or price of a business, people will often look at multiples of revenue, earnings or other metrics. These are referred to as rules of thumb. The use of rules of thumb is popular as they are simple to apply. However, their simplicity may also impact their reliability. For example, while applying a factor of 1.5 times gross revenue is a very easy mathematical exercise, it fails to take into account the cost structure of a business. Two businesses in the same industry with similar revenue but significantly different cost structures would likely not have the same value.
Rules of thumb are not a substitute for a proper business valuation. While a business valuator will consider various rules of thumb, this is merely one part of an analysis that considers the numerous unique characteristics of a business.
3. Simply Take Last Year’s Profit and Multiply by X
Often people assume a valuator will simply take last year’s earnings and multiply it by a standard multiple. There are two misconceptions in this belief.
First, valuations are forward looking. A prospective purchaser does not buy a business based on what it did in the past. Rather they base their decisions on what they expect it will do in the future. All valuations either explicitly or implicitly consider estimated future earnings or cash flows. While a valuator will often look to the historic operating results of the company being valued, this is done in the context of using the historical information as a basis for estimating the future.
Second, there is no standard multiple that is applied to all valuations. Multiples are dependent upon numerous factors that may or may not exist as at the valuation date. The valuator must carefully assess these factors and how they impact the multiple that would be appropriate to a specific business.
4. Valuations Are Not Needed
We often hear comments such as “I know what my business is worth, I don’t need a valuation”. In most cases, the assistance of an experienced business valuator is needed to assess the numerous factors that impact the value of a business. We often encounter situations in which business owners require assistance to properly apply the unique factors of their company to the relevant valuation model.
Additionally, the services of an experienced valuator can often help the business owner focus on factors that will drive the value of their business, thereby increasing the price realized for an upcoming sale.
Valuators also provide an independent opinion that may aid with the sales process, in litigation matters or with Canada Revenue Agency.