November 8, 2017 | Valuations
Whether you are a practicing attorney, an investor, or a small business owner there may come a time when you need to read and understand a report written to support a conclusion of value for a business. A well written valuation report is difficult to understand by those who are not well-versed in the terminology and principles of business valuation. Often, a well written report can mask serious deficiencies in assumptions and foundations for the valuation that render the conclusions irrelevant and/or wrong.
There are several very common errors that are easily identified by a valuation professional but might be completely missed by someone who is not accustomed to evaluating valuation reports. The following is a checklist to assist you in evaluating a report to at least catch basic problems and errors. Some of the most common errors follow:
Even the most sophisticated looking reports can contain mathematical or calculation errors. In a business appraisal, one error early in the process can have a dramatic impact on the conclusion of value. Even if you do not want to sit down with a calculator to verify the calculations perhaps you can delegate the task. Somehow, it should be done.
Mixing Tax Attributes
An example of the most common error with, often, the greatest impact on the conclusion of value is the application of pre-tax capitalization and discount rates to after-tax cash flows and earnings, and vice versa. Although this seems like an obvious problem and easy to see, it can be difficult to catch. If, upon reading the report, you cannot tell whether the capitalization/discount rate is pre-tax or after-tax you should call the author of the report and ask him/her to show you where it is stated in the report. This can be the beginning of a process that may result in the discovery that there is a mismatch.
Incorrect Standard of Value
Without getting too technical, this error is akin to getting a piece of chocolate cake delivered by the waitress when you asked for a slice of chocolate pie. The impact, though, can be much more significant. For example, you are involved in a stockholder dispute and as a part of the litigation process, a valuation report is ordered. If the appraiser reports the value on a Fair Market Value standard of value the report is irrelevant in most cases. Since the Fair Value standard of value is likely the appropriate standard of value in a dissenting stockholder action the appraiser has produced a report that may come to a correct conclusion (Fair Market Value) but cannot be used by the court because it presents an incorrect conclusion (Fair Value).
Misapplication of Market Data
Many business appraisers like to use publicly traded companies as “market comps” much as a real estate agent uses similar homes in a neighborhood to provide “market comps.” This is not the error. The error is using public company transaction data without adjusting for the additional risk associated with small companies (size risk) and the unique risks associated with the subject company (company specific risk). This error almost always results in an overstatement in the value of a company.
When valuing an interest in a business (less than 100%) the appraiser is likely to apply discounts for lack of control and lack of marketability. If both discounts are 20%, the cumulative impact may be reported as 40%. This would be incorrect and result in an understatement of value. This is so common that even courts make this mistake on occasion! (e.g. Kasman v Commissioner, T.C. Memo. 1996-112) The proper effect of the two discounts is not additive (20% + 20% = 40%). They should be applied sequentially (1-([1-20%] x [1-20%]) = 36%).
All of this may seem complicated and it is. That is why common errors can easily be missed by users of valuation reports. It may be well worth your money to have a professional valuation analyst review the report for you and provide a detailed analysis of not only errors but also weaknesses in the assumptions, methodologies, and conclusions. A Certified Valuation Analyst is trained in valuation and reporting and is qualified to do this type of work.
For more information about valuations, contact Filler & Associates.