Don’t overlook these Business Valuation fundamentals

Never Too Good to Revisit the Basics of Business Valuation

The business valuation literature is filled with detailed discussions on important, yet somewhat esoteric, issues and in-depth analyses of specific court rulings. We at Brady Ware have written numerous such articles and trust that you have found them useful and informative. I’d like to change things up a bit and remind us all of some fundamental oversights that still occur, especially when an inexperienced valuation professional is involved.

Unclear definition of the subject interest

Sometimes you need to dig a little deeper to uncover pertinent information.

For example, the subject interest in a valuation could be 1/3 ownership of the common stock of a company. If valued on a per-share basis, the chosen discount might be greater than if the 1/3 position had swing-vote characteristics due to no shareholder having a majority position post-transaction. This situation could make the block of shares more appealing to certain investors.

Incorrect selection of capitalization or discount rate in an income approach

Capitalization rates are used as a divisor to convert a single, likely current, benefit stream into an indication of value. If the benefit stream is reasonably expected to remain constant, a given capitalization rate could be appropriate. Discount rates are used to convert future benefit streams into an indication of value. If benefit streams are expected to fluctuate, and the fluctuations are somewhat predictable, then applying a discount rate to the future variable benefit stream makes more sense.

Another consideration is the potential impact of including the effect of debt in the benefit stream.  For example, if a benefit stream used in a discounted cash flow analysis does not include the effects of debt (interest and principal payments), then a weighted average cost of capital (WACC) should be used.  This discount rate discount rate blends the cost of equity and the cost of the interest-bearing debt in the capital structure.  Also, the value derived from discounting the benefit stream in this example is the value of the entire invested capital structure.  Therefore, the value of the interest-bearing debt must be subtracted to arrive at the value of the company’s equity.

Missing critical differences versus comparable companies

The use of companies from different industries is an obvious mistake when comparing comparable companies to establish a value for the subject company. Because it is so obvious, it is a mistake that is rarely made.

However, lack of industry experience can cause problems for the valuation professional attempting to establish a value for the subject company. The companies may be comparable but the characteristics that are the most important to compare between the companies may escape scrutiny if the level of industry intimacy is low.   Even if the companies are very similar in their operations, adjustments for differences in size, growth rates, geographic diversity, and management depth are almost always necessary.

Not accounting for legal entity differences

Finally, the corporate structure of an entity can affect the eventual valuation. Certain structures allow for tax benefits that would not be available if the legal structure were different.

For example, the acquirer of a partnership interest being valued may receive a step-up in basis that is not available to the acquirer of S-Corporation stock.

Of course, the specific fact pattern and circumstances in each valuation need to be analyzed to determine which valuation approaches are most appropriate and how adjustments to the calculated value will be taken into account and applied.

To learn more about how Brady Ware can help you and your clients determine the value of family limited partnerships and closely held business interests, contact:

Michael or 937-223-5247

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