Business Valuation - 5 common mistakes valuers make

So you're keen to develop your business valuation skills? Let's look at 5 common mistakes made in small business valuations.

1.  Can I complete the valuation of a family business relying on the detailed financial statements for the past 4 years?

Yes, but it would be a limited scope valuation.

A valuation engagement where the work to be completed by the valuer is limited by the client, or where certain necessary information is not available, must be qualified as a limited scope valuation. Many valuations that are completed are limited scope valuations, so this is not uncommon. A full valuation would require a mix of both financial and non financial information. The data in financial statements alone will generally not be adequate for preparation of a full valuation.

2.  You are completing an earnings based valuation and have been provided with the financial statements for the last 4 years. Can I rely on the net profit figures disclosed in the financial statements as a basis for the maintainable earnings?

No, you need to review all of the revenue and expenditure to establish maintainable earnings.

To arrive at maintainable earnings you need to regularise and normalise the earnings of the business. Whilst net profit may be your starting point, you would look at both the income and expenditure segments and adjust for abnormal and non recurring items together with other charges that may be more related to owners influence or timing recognition. The maintainable earnings of the business is normally that amount that can be maintained over time on an arms length basis.

3.  As the valuer do you have freedom in the selection of the valuation method?

Yes, subject to the constraints of the professional standards and any contract limitations.

A valuer should select the methodology most appropriate for the business being valued, other than where there are legal constraints such as a shareholders agreement which dictates the valuation method to be employed. Subject to this, in selecting the most appropriate valuation method the valuer, assuming they are a member of one of the accounting professional bodies, must follow the guidelines provided in the standard in selecting the methodology that will provide the most appropriate reflection of the business.

4.  What is the difference between the enterprise value and equity value of a business?

Equity value = enterprise value + net surplus assets – interest bearing debt.

The enterprise value is the value of the business in isolation whereas the equity value is the value of the entity that holds the business. Equity value allows for interest bearing debt, whereas this debt is ignored in an enterprise value calculation. Equity value also considers assets beyond the business that may be on the balance sheet. Whether you require an enterprise or equity valuation will depend on the purpose of the valuation.

5.  A lot of valuations that I see employ an earnings multiple of 3. Can I use a standard capitalisation rate for the majority of businesses that I value?

No, the earnings multiple of capitalisation rate is a measure of risk. You need to apply a rate that reflects the risk profile of the business.

The earnings multiple or capitalisation rate are a measure of the risk profile of the business. Your valuation should consider both the internal and external risks of the business. Having assessed the risk profile you would then look for different bases of comparable data that provides reference points for the range in which the multiple is likely to sit. With this information you exercise professional judgement to determine the appropriate multiple or capitalisation rate.