Common Pitfalls with Business Valuation
Business valuation is often described as “more art than science” – but it doesn’t need to be. Completing a business valuation is essentially answering two key questions – what return can I get from my investment and how risky is it?
In a listed company this is done regularly and updated daily (or more often) and is relatively easy to do – it is also easy in most listed companies to “draw comparisons” (the property equivalent of viewing recent sales in your street/area). In smaller privately held business neither aspect is easy.
What is my return?
This should be about finding out what is the “normal” profit / earnings I can expect to get – adding back unusual items ( or in some cases no business items that many SME’s include in their Profit and loss ) – for example additional contributions to the owners self-managed super fund (SMSF), non-market rent paid to a related entity etc – Once we go through this process we can work out the “normalized earnings” – return!
What is my risk?
This is about working out the various risks that affect that return – again in SME’s far more risk than listed companies – no structured reporting, often no audited accounts and more importantly often the business is largely or entirely dependent upon the owner / family, sometime the business is highly susceptible to new technology or disruption and often the business has key employees who are not “locked in” – all of these factors make your return more risky.
Higher risk = lower valuation multiples and therefore lower business value.
So the main pitfall is to focus only on one side of the valuation equation – the return and in fact the variable that has the most effect is the other side – risk!