1. Is this what you want to hear or what you need to hear?
M&A literature is full of articles noting that valuations are ‘more art than science.’ Reading between the lines, this means that brokers will all value the same company differently. More pertinently for business owners, it can mean that the broker’s valuation reflects the value that the owner attaches to their business rather than a more objective figure. This most commonly plays itself out as exaggerated growth figures. The end result is a valuation which may keep the owner happy but only serves to scare away potential buyers of the business.
2. The use of ‘comparable’ public companies
The ready availability of rich data for public companies makes it easy for business brokers to value their clients’ businesses using metrics obtained from ‘comparable’ public companies. Small- to medium-sized companies are seldom comparable in any way to public companies in their industry. Constantly updated analysis provided by experts like Aswath Damodaran is an excellent resource – just not particularly for private companies. The figures are rarely realistic unless the business broker can provide a watertight rationale for their using them.
3. Over-adjusting financials
Business brokers typically adjust operating income so that it only reflects recurring items. In some cases, this can amount to little more than an exercise whose aim is to massage the company’s operating profit. What’s remarkable about ‘extraordinary items’ is how ordinary they are; a business broker may work under the assumption that a litigation – to take one example of a non-recurring cost – was a one off event. But the next litigation will also be a one-off event. Not accounting for contingencies will ultimately lead to flawed valuations.
4. Misunderstanding what makes the company valuable
An oversight of many business brokers’ valuations is the assumption that cash flow will grow or decline incrementally over a 5-10 year period, overlooking almost all the factors that drive that growth. Their assumption is that the market will grow by 5% and thus, it follows that the company will as well. But it’s seldom that simple. The aggregate market is only one component of a companies’ value – with plenty more decided by changes in technology, strength in IP, management decisions and competitive factors. Failing to grasp where the value in a business really lies will inevitably lead to erroneous valuations.
5. Capital expenditure projections
Misunderstandings around capital expenditures and their effect on free cash flow projections are quite common, even among brokers. This usually arises from a misconception that capital expenditure is a ‘one off’ expense, when, although in many cases it may be discretionary, sensible capital expenditure is a central component of any company’s growth plan. Brokers that overlook this point risk exaggerated DCF valuations based on the flawed assumption that a company’s existing capital can be used to generate above-market growth.
Lee Smith is Managing Director of Verdani Investments who offer fair business valuations whilst safeguarding employees and creating legacy moments for founders.
To find out more and to get a valuation on your business, contact us by emailing email@example.com or calling us.