Business valuations are required for a variety of purposes, ranging from notional valuations such as income tax reorganizations, related party transactions and shareholder disputes, to open market acquisitions and divestitures. Despite the abundance of literature available on the subject, business valuations often contain errors and inconsistencies that render the conclusions meaningless, or worse, misleading. The consequences can be significant when the business valuation conclusion forms the basis of an actual transaction.
This newsletter sets out five common errors that are often made in business valuation (even among valuation professionals) and how to avoid them. Additional information can be found in the book entitled Business Valuation (Howard E. Johnson; Canadian Institute of Chartered Professional Accountants; 2012).
Unrealistic Cash Flow Projections
The value of a business is a function of the cash flow that a company is expected to generate in the future and the risks relating thereto. Cash flow forecasts are often prepared to aid in this regard. However, cash flow forecasts often contain errors and inconsistencies that cause the valuation conclusion to be meaningless or misleading. Common deficiencies in this regard include the following:
- Optimistic revenue expectations: most forecasts have an upward bias. There is a natural tendency to overstate a company's growth prospects. A breakdown of revenue by customer, product and service offering and other parameters can help in assessing the degree to which growth will be generated by existing customers vs. new customers; existing product and service offerings vs. new offerings, etc. Where revenue growth is expected through new customers or new product and service offerings, there can be added challenges or costs involved. While developing a detailed forecast is onerous and subjective, doing so forces the consideration of how growth can be achieved.
- Inconsistency with operating expenses: adequate consideration must be given to the operating costs required to generate projected revenues. In many cases, those preparing forecasts believe that the existing cost infrastructure cash be leveraged, such that profit margins increase over time, thereby resulting in much higher value conclusions. To help avoid these types of errors, the financial model should incorporate analytical tests, such as revenue per employee and other operational metrics that aid in assessing the reasonable of the expense projections.
- Capital expenditure requirements: growing companies often require additional fixed assets. In some cases this can be significant, such as where facilities expansion is required to accommodate revenue growth. The valuation model should incorporate capacity-related metrics relating to equipment; facilities; distribution assets and other categories to assess when capital additions are required.
- Working capital requirements: growing revenues generally leads to higher accounts receivable, inventories and other current assets. In many cases, these requirements are partially offset by higher accounts payable, accruals and deferred revenue. However, net working capital requirements usually increase, which represents a drain on cash flow and value. Metrics such as days' sales in receivables, inventory turnover and net working capital as a percentage of revenues can help in ensuring working capital requirements are adequately considered.
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