7 Mistakes to Avoid In A Valuation
Updated: Feb 2
Company valuation provides an estimate, based on objective criteria, of the fair market value of a company at a given date.
Business valuation can be useful for transactional purposes, tax purposes, or serve as a baseline strategy in a business valuation project.
However, some mistakes can be made in the process of a business valuation. We have compiled a list of the most crucial mistakes that valuators should be aware of when valuing a company.
1. Flawed or Inaccurate Valuation Methods:
The most common mistake is the use of an inappropriate method to value a company. There are 6 common methods that can be used in a valuation – each with its own criteria:
a) Market Capitalization: Calculated by multiplying the company’s share price by its total number of shares outstanding – appropriate for publicly traded companies, or private companies for which private demand can be determined.
b) Times Revenue: A stream of revenues generated over a certain period of time is applied to a multiplier which depends on the industry and economic environment – appropriate for companies that have low or no earnings, shorter reporting period or earnings which aren't reflective of the valuation of the company.
c) Earnings Multiplier: Instead of the times revenue method, the earnings multiplier may be used to get a more accurate picture of the real value of a company, since a company’s profits are a more reliable indicator of its financial success than sales revenue is - appropriate for companies that have low or no earnings, shorter reporting period or earnings which aren't reflective of the valuation of the company.
d) Discounted Cash Flow: This method uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value – appropriate when a company’s future cash flows have high visibility and are predictable.
e) Book Value: This is the value of shareholders’ equity of a business as shown on the balance sheet statement. The book value is derived by subtracting the total liabilities of a company from its total assets – appropriate for any companies with accurate accounting of their business.
f) Liquidation Value: Liquidation value is the net cash that a business will receive if its assets were liquidated and liabilities were paid off today – appropriate for companies whose assets and liabilities have strong market demand, and an easily established value.
Valuators must fully understand the businesses they are to value, prior to choosing an appropriate valuation method.
2. Too Much Emphasis on Rule of Thumb Practices:
Using general rules of thumb are a great starting point in any valuation. It is essential, though, to understand that every business is different. Rules of thumb are a good guideline or baseline but should not be used solely in the decision-making process. Businesses vary, and each valuation methodology needs to be tailored to the business rather than common practice.
3. Relying Too Much on Comparable Aspects:
Another mistake that valuators make is that they rely too much on comparable aspects. An example of this is the sole dependence on comparable transactions from other similar businesses. This is a great way to compile basic information, but relying too much on these transactions may end up valuing your business inaccurately.
4. Failing to Look for Errors:
A valuation is a long, arduous process, during which mistakes can be made. Before finalizing a valuation, valuators should go through their work with a fine-tooth comb and make sure that any errors, if any, are corrected and thoroughly investigated. Even the smallest error, or incorrect assumption, can make a company valuation inaccurate. And this can be detrimental if you are using the business valuation for purposes such as insuring your business or selling your company.
5. Not Using the Correct Standard of Value:
There are several basic standards of value, and the purpose of your valuation will determine which is best to use:
a) Fair market value - the value at which a business would change hands between a willing buyer and seller, acting at arm’s length in an open, unrestricted market.
b) Investment Value – the value of a business to a particular investor based on individual requirements and expectations.
c) Intrinsic Value – the value that an investor considers, upon evaluation of available facts, to be the true or real value, and in turn, the market value once other investors reach the same conclusion.
d) Fair Value – the value based on reporting standards, and legal standards. Depending on the judicial interpretation, the fair value may be an application of one of the other standards of value – such as FMV or intrinsic value.
It’s important to use the correct standard of value when completing your valuation.
6. Discount Rates:
Discount rates are often determined in relation to present cash flow and anticipated cash flow at any given time. Discount rates take things like payments, the stability of the industry, and the overall size of the company into account. If these rates are not assessed or calculated properly, they can affect the overall value of a company greatly and can skew the valuation.
7. Debt and Income:
Valuators need to be aware of the company’s interest-bearing debt in relation to its income and equity. Those valuations that do not take into account a company’s debt when valuing the company can lead to a very skewed business value, and pricey legal battles in the case that the company undertakes business transactions using this incomplete valuation.
A valuation has a huge bearing on any company, and it is necessary it be as accurate as possible. When looking at valuing a company, it is always best to find a certified company like Cerberus Consulting Services. Business valuation consulting can provide you with an accurate and correct business estimation. Contact us to get the services of one of the most experienced teams of business valuation experts in Alberta.