Valuating a business is a big undertaking, and business owners expect evaluators to provide them with the most accurate value for their business. Valuators can avoid many common mistakes during a valuation, and I will highlight a few that occur the most.
Valuators make common mistakes, such as selecting the wrong appraisal method, not considering the brand, and overlooking warranty obligations. Evaluating a business is not an exact science, but avoiding common mistakes is necessary to ensure evaluation accuracy and credibility.
Valuating a business is more than getting a high value, and I must emphasize that an accurate value trumps everything else. Using the correct metrics and avoiding common mistakes will make evaluating a business a pleasant experience every time you do a valuation.
7 Common Business Valuation Mistakes
Understanding and implementing the correct business assessment is vital to business owners. Assessments are necessary; owners need them to help calculate their business’s dependable values. Several common assessment mistakes affect a business’s value, and here are a few I want you to avoid.
Using the Wrong Valuation Method
Every appraisal method has advantages and disadvantages depending on the data’s availability, context, and purpose. A common mistake is using the wrong method or applying it inconsistently.
When you choose an appraisal method, you must compare it to the ratios of similar businesses, known as comps (Comparable company analysis). You should also consider the method’s limitations and strengths and how it compares with businesses of the same size and industry.
Using the comp analysis must include the following:
- EV/S (value to sales)
- P/E (price to earnings)
- P/B (price to book)
- P/S (price to sales)
If the business comp valuation ratio is higher than that of the average business of the same size and industry, the business is overvalued.
For example, avoid using market multiples without adapting it to the growth, size and profitability of the business.
Overlooking Warranty Obligations
A comprehensive valuation of a business must include examining its warranty obligations, and a common mistake a valuator makes is overlooking them during the appraisal process. A company’s warranty obligations include customer satisfaction, product quality, etc., which affect the value of a business to potential buyers.
Valuators bear the weighty responsibility of assessing and calculating the necessary provision using a severity and frequency methodology. It’s often overlooked that future claims under warranties can significantly impact a business’s value.
For example, if a business sold a product for $50 with a 2-year warranty valued at $10, the company would identify $40 of revenue and $10 as unearned warranty revenue.
Overoptimistic Growth Projections
Most valuators consider a business’s value without considering its potential growth, and a common mistake is to overestimate it. Predicting growth is an easy way to boost a company’s value, but many times, the predictions are unrealistic and based on assumptions.
The best way for you to avoid overestimating a business’s growth potential is to be conservative and realistic in your predictions and to use:
- Historical data
- Market research
- Industry benchmarks
For example, a business that assumes a high percentage growth when there is a possible market shift due to competing products or consumer decline can lose value.
Not Accounting for Key-Man Risk (Dependency on Owner)
A business’s success often hinges on its owner or key people, and overlooking their absence can have significant consequences. Disproportionate reliance on an owner or key personnel may devalue the business during a sale.
It is vital that you consider how dependent the business’s stability, scalability, and success are on the owner or a specific person or team because this will limit the buyer pool and reduce its value.
Another common mistake related to owner dependence is dependence on top clients. Valuators often do not consider the dependence the business has on a singular or small group of top clients. If a business relies heavily on one or a small number of clients, it is at high risk.
Although a big client adds value and produces good financial numbers, losing that client could devastate a business. Buyers consider the loyalty of big clients to owners or key people and how it will impact the company if they leave.
For example, purchasing a tech firm whose success is directly attributed to the vision and knowledge of its lead developer would lose value since customers and investors frequently place more faith in the individual than in the company’s product.
Not Considering the Value of the Brand and Goodwill
Some businesses are worth more than their competitors due to brand recognition, customer loyalty, and goodwill. Many valuators need to include or correctly calculate goodwill and brand recognition.
A question I am often asked is how to quantify an intangible asset like a company’s brand and goodwill. First, I tell evaluators to always consider the business’s reputation and, second, to use customer and employee surveys and market research to get the most accurate value estimation.
For example, a business with a popular and tested brand like “Nike” has a strong consumer base, loyal to the brand that boosts and ensures future sales.
Not Assessing Market Conditions Trends and Interest Rates
The market shows whether there is a demand for businesses in your industry, and many evaluators need to keep up with trends or account for that demand. Economic downturns, customer behavior, and other factors influence market conditions, and it is essential to consider these influences when performing valuations.
As a valuator, I stay informed, analyze, and conduct proper market research with every valuation to avoid costly mistakes.
Interest rates and their effect on a business’s value are tied to market conditions. Valuators often do not consider this impact.
A business with a stable cash flow handles debt better in a low-interest-rate environment, which is a good indicator for potential buyers. Negative free cash flow, on the other hand, shows that the business must raise money, which will affect a buyer’s decision.
For example, when inflation is high it can eat into the value of potential cash flows. With low interest rates it can increase the present rate while decreasing the discount rate.
Not Using the Correct Earning Stream
There are several ways to measure a business’s value, such as cash flow, net income, SDE (Seller’s Discretionary Earnings), or EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). A common mistake a valuator makes, especially with small businesses, is thinking that one measuring tool fits all.
Using the wrong earning stream to value a business is common and happens the most frequently. Take EBITDA as an example. Valuing a company that is too small for EBITDA will lead to overvaluation, and using SDE on a business that is too big will lead to undervaluation.
Conclusion
Not assessing market conditions, trends, and interest rates or not accounting for key-man risks are common valuation mistakes that can have severe implications for a business. As a valuator, you must avoid these mistakes and give business owners accurate and reliable values.
