As we all know, buy/sell negotiations, business disputes, or divorce proceedings can involve a business that more often than not must be negotiated and potentially divided. When valuation experts value such interests, the interested party and/or their attorney must be able to critique the report prior to any negotiation or presentation in litigation.
We’ll assume for now that all analysts are qualified. However, among the goals to be achieved in reviewing a BV report are:
- Which valuation can be best supported in an accurate and unbiased manner?
- What are the vulnerabilities in my own expert’s report?
- What are the problems in the opposition’s report that can be used as leverage in mediation or trial?
- Is the Value reasonable for the information available?
There are number of things to consider that differ depending on which combination of approaches to business valuation (BV) you use (i.e., Asset-, Income, Market-Based). We all expect appraisers to be independent but that’s not always the case. So the first thing to look for is bias (to be discussed later) and, if not found, then start to look for assumptions that can’t be supported and, of course, inaccuracies.
Capitalization and Discount Rates
Under the Income Approach, capitalization rate is derived and used to value a business by dividing it into Net Adjusted Income. The lower the cap rate, the higher the value the company will be. In order to understand this rate, it is necessary to break it down into its components. In breaking down the cap rate, look at two factors (among others): sustainable growth rates based on historical financial results, current economic conditions, etc. and company-specific risks (size, volatility, industry, debt, customer/market dependency, etc.).
These can also be compared to benchmarks for similar sized companies and industries. Valuations are highly sensitive to the capitalization and discount rates used with various Income Based approaches. Again an unnecessarily low (high) cap rate results in higher (lower) value.
The Discount Rate is impacted by the same factors as capitalization rate before sustainable growth rate. Recall Discount Rate – Sustainable Growth Rate = Capitalization rate. Discount rates are used to discount future cash flows to present value. This method is best used with high growth companies in years 1-3 but expected to mature to a more sustainable rate of growth in years 4-5+. This method is highly sensitive to key variable assumptions used in the analysis. As above, an unnecessarily low (high) discount rate results in higher (lower) value.
These are just a few things to consider when evaluating a BV report. Other methods including Market Approach will be discussed in Part II….
Brad Burns, CVA, CFA
Burns Valuation Consulting