5 myths and truths about business valuation
Entrepreneurs, business owners and investors often misunderstand the business valuation process and its final results. Please find below five myths and truths about the art and science of a valuing a business. Myth #1: There is no difference between “price” and “value” Truth #1
- While the terms “price” and “value” may sound synonymous, there may be significant differences.
- The value of a business is determined through careful analysis, by an experienced valuation professional, considering numerous factors regarding the nature and of the business, the industry and economy in which it operates. The valuator will consider a number of valuation approaches in order to arrive at a valuation conclusion that will provide a notional investor with a reasonable return on investment, given the risks of the business. This is often referred to as a ‘notional’ valuation.
- The price of a business may differ from the value indicated by a notional valuation. Some of the factors influencing price include different purchaser vs vendor negotiating abilities, financial strengths, structure of the transaction, synergies, etc. These factors and the price of a business can only be determined when a business is exposed for sale in the open market.
Myth #2 A company’s value does not change over time Truth #2
- Value is determined at a specific point in time.
- Businesses are constantly in a state of transition as a result of fluctuations in their business structure, product lines, management, financing arrangements, general and business specific economic conditions, industry and competitive conditions, etc.
- Many internal and external changes that affect the prospects of the business typically lead to changes in value.
Myth #3 A valuator should arrive at the same value of a company no matter of a valuation approach Truth #3
- The income, market and cost approaches are the three generally accepted valuation approaches. The selection of valuation approach depends on the facts and circumstances of the subject company.
- In a valuation analysis, the valuation approach(es) and method(s) most appropriate in the circumstances would be applied, considering the availability of relevant data.
- The resulting value indications from the approaches and methods applied would be evaluated and weighted, on a qualitative basis, as appropriate. In many cases, a greater weight may be to a particular approach. For example, when the guideline companies are not truly comparable to the subject company, a greater weight may likely be placed on the indication of the income approach.
Myth #4 The value or price of a business may be determined using rules of thumb Truth#4
- When trying to determine the value or price of a business, people will often look at multiples of revenue, EBIT, EBITDA or other metrics. These are referred to as rules of thumb.
- The use of rules of thumb is popular as they are simple to apply. However, their simplicity may also impact their reliability. For example, while applying a factor of 3.5 times gross revenue is a very easy mathematical calculation, it fails to take into account the cost structure of a business. Two businesses in the same industry with similar revenue but significantly different cost structures would likely not have the same value.
- Rules of thumb are not a substitute for a proper business valuation. While a business valuator will consider various rules of thumb, this is merely one part of an analysis that considers the numerous unique characteristics of a business.
Myth #5: A minority interest is the same as a value of a controlling interest where each is calculated on a “per share” basis Truth #5
- The primary reason that a minority shareholding may have less value per share than does a control shareholding is related to the minority shareholder’s inability to:
- Influence business operations and business strategy.
- Dictate the amount and timing of the return on his/her investment.
- When the valuator determines the value of a minority interest, these factors often result in discounts from what otherwise would be the value per share. Such discounts are referred to as “minority” or “non-controlling” discounts.
Marek Panfil, Ph.D, Assistant professor of Finance at Kozminski University. He has over 10 years of experience in business valuation, including two years at Ernst & Young (EY) Vancouver (Transaction Advisory Service, Valuation and Business Modeling). If you want to:
- Learn valuation tools and understand the impact of business decisions and capital markets on a company value.
- Boost your expertise and confidence in discussing company valuation issues from start-ups, over privately and publicly-held corporations to M&A and LBO.
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- Obtain the Certificate of Professional Excellence in the specialised field from the top business school