September 17, 2018
When owners and managers receive business valuations, the first thing they typically do is flip to the conclusion: What’s it worth? Often, little attention is given to the analyses underlying the final number, especially if the report was prepared for internal planning or financial reporting purposes. But it’s always a smart idea for the company’s owners and managers to peel back the curtain and see what drives value.
Why the Analyses Matter
Valuation reports should be written in clear, easily understandable language so that the user of the report can easily grasp the concepts. Appraisers also may personally deliver the valuation report and then sit down with the client to review the report and answer any questions.
This serves two purposes. First, it ensures that the valuation is based on accurate information. If mistakes or omissions are discovered, this meeting gives the appraiser one last chance to revise his or her conclusion. Second, the meeting can provide insight into ways that owners and managers can maintain — or help grow — the company’s value in the future.
What Valuation Reports Cover
The American Institute of Certified Public Accountants business valuation standard (VS Section 100) provides a useful roadmap for valuation reports. Here are some relevant “landmarks” to review in order to get more from your valuation report.
- Non-financial Information. The valuation report will discuss qualitative information needed to understand the subject company, including its:
- Products and services,
- Marketing strategy,
- Sales and distribution methods,
- Organization structure,
- Management team, and
- Nature, rights and restrictions of the equity ownership interests.
The appraisal reports may identify strengths and opportunities that can add value if acted upon. They also may unearth risks and threats that need to be mitigated to preserve value.
- Financial Information and Analysis. Appraisers evaluate the subject company’s historical financial information and compare its performance to similar businesses. This may include ratio, common-sized financial statement and time series analyses. When a company’s performance is benchmarked against its peers, it gives owners and managers insight into its position in the market and provides goals to match industry leaders.
Appraisers may use the company’s historic financial data to estimate future cash flow. In turn, the appraiser’s analysis can serve as a starting point for management’s future budget and business plans. Alternatively, valuators may rely on management’s future cash flow estimates. If so, owners and managers may ask whether internally-prepared estimates appear reasonable in light of the appraiser’s research.
- Valuation Techniques. There are three approaches to valuing a business: the cost (or asset-based), market and income approaches. There are various methods under each approach. For example, two common methods under the income approach are the capitalization of income and discounted cash flow methods. When reviewing this section of a valuation report, you should understand why the appraiser selected certain methods and discarded others. Then learn the mechanics of how the preferred methods were applied to your financial data to arrive at the company’s value.
- Valuation Adjustments. The most common adjustments to an appraiser’s preliminary value estimate are for lack of control and marketability. When reviewing this section of the report, you should understand what these valuation discounts are and why they did (or did not) apply to your business. For example, it’s common for appraisers to factor lack of control into cash flow estimates, rather than to take a separate discrete discount for lack of control. Others types of adjustments include key person discounts and swing vote premiums. If you see adjustment for these items, ask for explanations.
- Non-operating Assets and Liabilities. Some companies possess assets and liabilities that are not used in normal business operations. Or they may have excess or deficit operating assets compared to other companies in similar business lines. Appraisers may need to add non-operating and excess assets to their preliminary value estimates — or subtract non-operating liabilities and deficit operating assets.
- Industry and Economy. Appraisers factor external conditions in the company’s industry and the local, national and global economy when valuing a business. This section of the report should provide more than boilerplate. It should explain how industrial and economic trends relate specifically to your business.
Why You Should Speak Up
Appraisers can provide an objective outside perspective on how your business runs — and how it can be improved. But no one knows a business better than its owners and managers. When your appraiser discusses the analyses underlying his or her conclusion, take the opportunity to ask questions and play devil’s advocate. Doing so will strengthen both parties’ understanding of how the business operates and what ultimately drives its value.