10 Common Business Valuation Mistakes

This blog post will look at a sample of 10 mistakes that are often made in a business valuation.  


#1.  Unrealistic projections of revenue

One of the most common types of revenue projections is the classic “hockey stick” projection.  This is a type of forecast where revenue suddenly shoot up in the forecast period by applying a suddenly high growth rate.  There are obviously some concerns with this.  Bear in mind that this is not to say that it's not possible for a company to follow a hockey stick revenue growth trajectory, but it does require some serious scrutiny. 

Some questions that should be asked:

• is the growth in line with the industry?
• what is the size of the market?
• what is the company's strategy to achieve this growth?
• what is the economic outlook for the region the company operates in?
• what is driving the growth?   Is it new customer acquisition...   increase in market share.... acquisitions...  innovation...  new product offering?  
• how sustainable is it? 

It is important to have a very close look at what is driving the growth in revenue.  It would be prudent to look at the specific levers of growth to understand if they are realistic and sustainable.  When a business valuation simply

How to Calculate the Equity Risk Premium in a Business Valuation

Slightly wonkish blog post on equity returns ahead....

When valuing a privately held business, it is important to properly calculate the business’s total cost of capital in order to correctly capitalize or discount its cashflow. The basic premise of business valuation is that a business is worth the present value of its future cashflow, therefore discounting the future cashflow of the business at the appropriate discount rate is crucial.

What is the cost of capital for a business?

The weighted average cost of capital is the discount rate most often used to discount the future cashflow of a business. It reflects the time value of money and risk associated with the business’s future stream of unlevered cashflow (cashflow that accrues to equity holders and debt holders).

A business's capital structure is composed of its debt and its equity. Determining the company's total cost of capital basically entails taking its cost of debt (which is usually an interest rate) and its cost of equity (to be discussed below) and then taking the weighted average of the two based on the company's optimal capital structure (this is called the weighted average cost of capital, the WACC). Without getting too wonky (too late), it's very important to properly calculate this because the WACC is used to present value or capitalize the future cashlfows of the business, which is the key step in a business valuation.
So.... if your WACC is wrong then your business valuation conclusion can't be right. This post will look at the equity risk premium, which is a component of the total cost of equity which, in turn, is used to calculate the total cost of capital for a business.
Let's back up one step - what is the cost of equity??

The cost of equity is simply the return that equity investors expect to make on their investment in a business.

Business Valuation for Tax & Estate Planning

This blog post will discuss the concept of an estate freeze, which is a commonly used tax and estate planning tool. We will also discuss how an independent business valuation is an important part of that process.

What's an estate freeze?

Section 86 of the Income Tax Act allows for the tax-free exchange of shares in specific instances. It is commonly used for estate planning purposes. Section 86 generally allows for the transfer of one's shares to be done at fair market value, tax free. Generally, the owner of an operating company can exchange their common shares for preferred shares at fair market value and then issue new common shares to a person (such as a child) and then the child's common share value would be based on the growth in value of the company. At a high level, this is what is referred to as an estate freeze.

A simple example –

Suppose a single mother (Mrs. Smith) is the sole shareholder of her company that she started up from scratch over 20 years ago using her hard work and sweat (BusinessCo Inc.).  BusinessCo Inc. is now a highly successful service company and Mrs. Smith's shares are worth $1 million today, according to a recent business valuation she had. Based on the company's

Business Valuation and the Risk Free Rate

Government bond yields are at historic low levels in Canada and across the developed world (see the table below that charts the yield of the 10-year Government of Canada bond, over a 5 year period). This has very important implications on the values of businesses (and other assets too, but this post will stick to commenting on business equity values). This blog post will examine the impact that historically low risk free rates have on the cost of equity in a business valuation.



What’s the risk free rate?

Simply stated, the risk free rate is the theoretical return that would be earned on a theoretical investment that has no risk of loss. In other words if you invested money into a risk free investment there would be zero risk of loss to you. Government bond yields (in rich, developed countries) are usually used as a proxy for the risk free rate as these bonds are thought to be without risk to investors. Some people may dispute this notion, especially after listening to the congressional debate about the debt ceiling in the United States. As an aside, the real risk free rate is probably even lower than government bond yields since sovereign risk has likely

Taxation Issues in Business Valuation

A business valuation engagement triggers many questions about how taxes may impact the valuation. This blog post will touch on some of the more common tax considerations that arise in a business valuation engagement.

The first important question is -- what is the valuation approach? Is the business a going concern or is it a liquidation situation?

Going Concern Approach

If the business is viable and is a going concern, the following are some more common tax issues that come up in a business valuation:

What is the type of corporation?

Is the business a partnership, a joint venture, a Canadian Controlled Private Corporation (CCPC), private corporation, public corporation, and so on..? The type of corporation it is will impact the level of taxation.

There could be a situation where the business was incorporated as a CCPC and is entitled to the small business deduction and therefore would be taxed at a lower rate. However, it may be determined that after a purchase that it would no longer be a CCPC and not entitled to the small business deduction and therefore the tax rate would be higher. If this is known in advance then the tax rate used in the valuation should not include the small business deduction. If it is not known with a high degree of certainty then the business valuator would have to apply the most reasonable income tax rate to the valuation.

Tax implications in an income-based valuation approach

In an income approach business valuation, the future cashflows of the business are forecasted and discounted to the present value using a discount rate to account for risk and the time value of money. This is referred to as the income approach. Sometimes a cashflow at a single point in time is capitalized (with a growth rate