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Part of Valuation methods start from two definitions of profit, and that is where they diverge
Valuation methods mistakes usually enter through the base figure, not the maths
Nine valuation mistakes grouped by where the error enters, in the base figure, the period, the comparison or the way the answer is stated, with the correction.
A valuation mistake is a mechanism fed the wrong thing. The wrong thing usually enters at one of five points: the base figure, the years used, the comparables chosen, the adjustments made, or the way the answer is stated.
The nine below are arranged by where the error enters, so you can check your valuation at each one. For each, the mechanism it corrupts and the correction.
What to take away
- Most valuation errors are not arithmetic. They are an input that does not mean what the method assumes it means.
- The last two mistakes are about how the answer is stated, and they cause more lost negotiations than the first seven combined.
- A sale of this size warrants an intermediary, an accountant and a lawyer; the accountant is the person who catches the first seven, and the intermediary the person who tells you what the market makes of the last two.
Errors in the base figure
Using revenue as the base. Revenue measures activity, not what survives it. Two businesses with the same turnover and different margins are different assets, and a method that starts from revenue cannot tell them apart. Correction: start from earnings on a stated basis, and treat any revenue-based figure as a rough screen at most.
Base figure error checks
- Revenue is activity, not what survives it
- Match earnings definition to the buyer
- Add-back must be documented and non-recurring
- Apply the third test hardest
Using the wrong earnings definition for the buyer. The owner's total benefit from working in the business and the operating result after a market-rate manager is paid are different figures, and each is right for a different buyer. Presenting the first to a buyer who will hire a manager is not a negotiating position; it is a sign you have not read the buyer. Correction: establish which buyer you are talking to and state the basis. The valuation methods guide explains the two.
Adding back costs the buyer must repeat. Maintenance deferred, a role left unfilled, marketing cut: these look like discretionary spending and are actually arrears. Adding them back inflates the base with money the buyer will spend immediately. Correction: an adjustment must be documented, genuinely non-recurring, and something the business would run without. Apply the third test hardest.
Errors in the period
Averaging across a trend. An average of several years hides the direction, and the direction is what a buyer is paying for. Correction: weight recent periods, show the trend, and explain it.
Average versus trend
Averaging across a trend
- What it hides
- The direction
- Why it misleads
- Buyer pays for direction
- Correction
- Weight recent periods
Treating unusual year as run rate
- What it hides
- The ordinary year
- Why it misleads
- Projects a coincidence
- Correction
- Remove the unusual cause
Treating an unusual year as the run rate. One exceptional year, up or down, tends to be followed by an ordinary one. This is regression toward the mean, and a valuation that projects the exceptional year forward is projecting a coincidence. Correction: identify what made the year unusual, remove it, and value what ordinarily happens.
Errors in the comparison
Using asking prices as comparables. Listings are hopes. Only completed transactions, with terms, are evidence of what buyers pay. Correction: if you cannot see completed deals with their structures, the market method is not available to you; set it aside rather than feed it listings.
Evidence versus rumour
Evidence
- Source
- Completed transactions
- Terms
- Structure disclosed
- Use it
- Market method available
Rumour
- Source
- Asking prices
- Terms
- Headline only
- Use it
- Set the method aside
Ignoring the structure behind a comparable price. A headline that was half earn-out, or paid partly in a seller note that was never fully repaid, is not the number it looks like. Correction: a comparable without its terms is a rumour. The deal structures page explains why the same headline can be worth very different amounts.
Errors in the answer
Stating one number. A valuation is a range with reasons. A single figure carried into a negotiation invites the other side to attack its precision, and precision is the weakest part of any valuation. This is false precision: decimal places on a judgment. Correction: carry a range, know the reasons for both ends, and know in advance whether you would accept the lower one.
Answer errors to avoid
Do you state one number?
Carry a range with reasons
Know both ends and the lower one
Choosing the method by the answer it gives. The most common error of all, and the hardest to see in yourself. An owner who runs three methods and reports the highest has not valued the business; they have chosen a number and found a method to justify it. Correction: run the methods whose inputs you have, report all of them, and treat any disagreement between them as information about the business. A disagreement between methods is usually pointing at something the flattering method could not see.
Checking your own work
Go through the list against your valuation in order: base, period, comparison, answer. At each point, ask what the method assumed and whether the input satisfies it.
If you cannot answer for a given point, a buyer's accountant will start there, and diligence is a much more expensive place to discover it than your own desk. That is exactly what the preparation year exists for.
