#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
applies a long term growth percentage without some level of explanation then that should raise some questions for you. The issue of bias should also be considered if it is not an independently prepared valuation.
#2 Profit margins increase dramatically
The flip side of the coin to the 'hockey stick' revenue forecast is a situation where revenue is growing consistently year over year and operating margins seem to get better each year into the forecast. A commonly seen forecast is one where fixed costs remain flat while revenue grows at an increasing margin. Really? In such a forecast it would be prudent to analyze the efficiency and capacity of the business. Perhaps the physical location is at capacity or the support staff are already over worked or management is spread thin. The point is to really develop an understanding of the business to see what the cost structure is and what the operating leverage of the business looks like.
#3 Working capital needs are underestimated
In an environment of growing revenue, the increasing working capital needs of the business are a use of cash. In other words, if revenue goes up it is likely that accounts receivable will also go up, inventory will go up. Forecasts which neglect to consider the cashflow impact of working capital needs will likely misstate the value of the business. In a business valuation it is important to model out the sources and uses of cash and analyze the net impact on the company cashflow.
#4 Future capital expenditure needs are neglected
Businesses that have fixed assets need to re-invest in them. Valuations which suggest that capital expenditures can be avoided are lacking and most likely overstate the value. If the business is growing, additional capital expenditures needs to be factored into the valuation to support that growth. If the business is expected to remain at steady state then there should be some consideration made to account for the existing fixed asset based that will need to be replaced eventually.
#5 Redundant Assets Are Not Added to Company Value
When valuing a company, if the the company owns redundant assets (assets that are not required for the business's operation) then those asset values should be added to the company's value. For instance, if a company owns a piece of land that is not being used, or if the non-cash working capital is extraordinarily high or if there was a piece of machinery that was not being used – then these could be considered redundant assets and added to the company value.
Please bear in mind that there may be tax considerations involved in valuing redundant assets that should be factored into the valuation. Example – imagine a vacant lot that is not used by the business. It may be worth $100,000 but have a cost base of $25,000 therefore there is an unrealized gain that would be subject to taxation upon disposition that should be considered in the valuation.
#6 Reliance on Valuation Rules of Thumb
Consider a hypothetical scenario between two business owners of 2 different retail pet food stores: Business A makes approximately $500,000 per year in revenue and Business B makes approximately $600,000 in revenue. Owner A has an offer on his business for $250,000 and tells this to owner B. Owner B assumes that his business should also be worth 50% of his company's revenue, $300,000. After all, Owner B heard 'somewhere' that businesses like his usually sell for about 50% of revenue so Owner A simply validated what he already knew to be true.
However, after closer examination:
- Business A leases far more retail space than it needs therefore its rent expense is much higher than B's
- Business A specializes in medical pet food for cats, a very small niche market with higher margins
- Business A is in Sudbury and Business B is in Toronto – two very different markets
- Business A offers pet grooming and bathing services, Business B does not
As you can see the 2 businesses are not exactly apples to apples comparisons. The point is that applying a valuation rule of thumb here is dangerous. The revenue rule of thumb also fails to account for differences in cost structure, growth, market, outlook, and so on.
Rule of thumb EBITDA multiples (multiples of Earnings Before Interest & Taxes) are also often used in the marketplace to compare the “value” of businesses but these can have some challenges too. Businesses can have very different tax rates, capex needs and working capital needs but these variables would not be captured in the EBITDA amounts. Theoretically these differences should be captured in the EBITDA multiple but this is not easy to do. EBITDA multiples are a great way to do a secondary check on value but should not be used as the primary valuation methodology.
#7 Using sale of comparable companies as a primary valuation methodology
This entails looking to data of recent transactions of businesses that are sold and applying ratios (like Enterprise Value to EBITDA) to the subject company. This is a good secondary test of value for reasonableness but should not be used as a primary business valuation approach. The first issue with this method is that getting good data on privately held businesses is very difficult.
Other reasons include:
- The price of the business may not be all cash. The price may include an earn-out or vendor financing. Fair market value assumes an all-cash consideration therefore this may not be an apples to apples comparison.
- The motivation of the parties is not known. If the buyer is lukewarm to buying and the seller is highly motivated then the transaction may not be at fair market value.
- The reported profit (net income, EBIT, EBITDA, etc) in the deal may not be normalized and therefore the implied ratios in the transaction are off. Example, the reported EBITDA in the deal is $500,000 but the owner paid himself a $200,000 salary which is way above market rate.
- The buyer might be a private equity group and the seller might be business owner who has never bought or sold a business – the negotiating ability of the parties is lopsided and perhaps the buyer got a better deal than they otherwise would have.
- Perhaps the owner took the first deal that came along and did not shop the business on the open market.
#8 Using public company data as a primary valuation methodology
There is a temptation to look at public company data for metrics to apply to value a similar privately held business. After all, a public company publishes its financial statements regularly and the stock price is known. Looking at publicly traded company data could be a good secondary test of value but consideration must be paid to the differences, which include:
- public companies are priced at minority positions (a single share) whereas a privately held company is usually valued en bloc (the entire business) or some amount above a single share. Therefore this is not an apples to apples comparison. Minority positions in a business are usually worth less, on a pro rata basis, than the en bloc value of the company.
- The shares in a public company are much more liquid than the shares in a private one, which impacts value. There is a market in place to buy or sell them (the stock market) but a private company is much more difficult to sell.
- Public companies usually have more access to capital than a private business
- Public companies usually have professional management in place and are much larger than private companies
#9 Data errors
This is a catch-all category which includes issues such as:
- including a growth rate in the cashflow projection and in the discount rate (accounts for growth twice)
- Not normalizing earnings correctly (adding certain expenses back to profit even though they are clearly business. ex. Cell phone expenses are discretionary in the day and age... really???)
- Applying a cost of equity to unlevered cashflows (cost of equity to be applied to equity cashflows, weighted average cost of capital applied to unlevered cashflows)
- using the wrong tax rate
- Applying EBTDA multiples to EBIT, and many more...
#10 Failing to look to what the future holds for the business
Business valuations that don't take into account the outlook of the business and stick to merely capitalizing the average of the last 3 years of cashflow can miss the current opportunities for the business and other important elements of what drives value for the business. Business valuation is really about the future of the business, not its past. In a business valuation assignment we certainly look to past results for some perspective but we do so in order to understand what they might tell us about the future.
This blog post is for general informational purposes only. Please consult a professional to discuss your individual needed.
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