5 mistakes to avoid when determining a company’s value
Whether you want to buy a business, sell yours or offer shares, assessing the value of the company in question will be inevitable. During this process, it is extremely important to avoid making some valuation mistakes. Rachel Chong, Director, Growth & Transition Capital at BDC says “it can result in a transaction not occurring because of unrealistic expectations or, on the other hand, selling your business for less than it’s worth.”
Figuring out the value of a business is a complicated exercise. A variety of methods can be used and valuations can be made with different degrees of detail and assurance. Even different business valuators may not come up with the same figure.
Here are five top mistakes that Chong says you should try to avoid when determining what a business is worth.
1. Having unrealistic expectations
It’s common for business owners to have an overly optimistic view of their company’s value. This can be because of unrealistic assumptions about future earnings or cash flow, a poor understanding of buyer appetite for their company or lack of knowledge about how companies are valued.
As a result, entrepreneurs can end up questioning the results of an outside valuation. “Entrepreneurs may feel that the valuator doesn’t believe in them if they have unrealistic expectations about the value of their company or its future growth,” Chong says.
At the same time, buyers can also have unrealistic expectations about a target company’s value. For example, they may be ready to pay a premium for the business because of expected synergies, but buyers often underestimate the costs of an ownership transition and overestimate savings from the merger.
2. Trying to do your own valuation
Valuation is a complex process that can involve various methods and levels of complexity and assurance. The choice of valuation approach depends on the type of company and transaction, and available information.
Mistakes often happen when entrepreneurs try to determine a company’s value without the help of a chartered business valuator. Some common errors include:
- using a valuation method unsuited to the type of business or its level of returns or cash flow stability
- inappropriately mixing valuation methods
- failing to normalize earnings by adjusting for special factors, such as discretionary and non-recurring items, and non-market-rate revenues and expenses
- applying an inappropriate multiplier of EBITDA (earnings before interest, taxes, depreciation and amortization)
- using the book value of assets rather than fair market value
- making unrealistic assumptions in cash flow or earnings projections
- ignoring changing sales trends
- failing to consider governance and ownership transition capacity
3. Not sharing information
When hiring a business valuator, you must be ready to share detailed information about the company and work collaboratively. “Some entrepreneurs may feel uneasy revealing confidential information,” Chong says. “But providing all the needed information is essential for a realistic valuation.”
As well, the process involves more than just supplying numbers and awaiting a valuation figure. Valuators often need to make on-site visits, meet key personnel and ask follow-up questions to understand the business. “It’s an involved process,” Chong says.
4. Expecting a fixed value
Valuation isn’t an exact science. A valuator is unlikely to give you one precise value for the company that everyone in the market will accept. “A common misconception is that valuation gives an exact value,” Chong says. “You can’t just apply a multiple.”
Valuators generally offer a price range that the company would probably sell for to an arm’s-length party. (This means a buyer who doesn’t have a reason to pay a higher or lower price than fair market value. For example, a family member may be able to get a cheaper price.) You can expect a wider range for smaller companies and businesses in certain sectors, such as technology.
The valuation also reflects the company’s stand-alone value. (This means the company’s value without any potential synergies or strategic considerations from the buyer.) It’s common for this figure to be different from the final transaction price. The price can be affected by factors such as:
- the buyer’s strategic interests or expected synergies
- the owner’s eagerness to sell
- due diligence
- available financing
- the company’s capacity to smoothly transition to new ownership
5. Expecting valuation to stay the same
It’s common for business owners to mistakenly assume that a valuation will remain valid over time. This can cause conflict among owners. For example, an owner’s family members may become upset if the business is sold and its value subsequently rises.
In fact, a company’s value can change for many reasons, including market conditions, new regulations and sales trends.
Want to go further?
Discover which factors affect the value of a company and find out what steps you need to take to establish a fair price when buying or selling a business in our free guide for entrepreneurs: Business Valuation.