Valuation issues frequently arise in litigious situations where testimony is required of a business valuation expert. Examples of these cases include shareholder disputes, diminution in business value claims, dissenters’ rights proceedings, post-transaction disputes, family law matters, and minority shareholder oppression actions. Too often, people purporting to be business valuation experts utilize canned, mechanical approaches that lead to unsupportable analyses and unreasonable conclusions. The following are 10 common pitfalls attorneys should be aware of when scrutinizing a business valuation analysis.
If the legal parameter provided by the attorney on a case is to value an asset or business as of a specific valuation date, then it is typically inappropriate to rely on company information or market data (such as economic events or transactions of other businesses) that was not known or knowable as of that date.
Generally, the assets and liabilities shown on companies’ balance sheets, which are prepared in accordance with generally accepted accounting principles (GAAP), are stated on a historical cost basis, not a market value basis. Thus, a valuation expert relying on the net book value of a company (i.e., the balance sheet value of assets less liabilities) will typically misstate its true market value. Another reason for the resulting misstatement is due to the fact that the intrinsic intangible assets of a company (e.g., patents, customer lists, trade names, goodwill, etc.) are not on the balance sheet. Even if they are, they are typically recorded on a historical cost basis. Similarly, a company could have unrecorded liabilities (e.g., environmental claims), which would cause net book value to differ from market value.
The valuation of a company is typically based on its expected future results because that is what a buyer will be enjoying upon the purchase and that is what the seller will be giving up in a sale. Past results are only relevant to the extent that they are reflective of what would reasonably be expected for the future. For example, if the latest 12 months’ results do not reflect the impact of a new 10-year contract that the company was awarded, then reliance on the historical results alone would tend to understate the company’s value. Too often, a valuation expert will simply extrapolate past results (e.g., a five-year average of earnings) and mechanically base the valuation analysis on this number. By doing this, the expert is implicitly assuming that this financial result is reflective of what will reasonably occur in the future. Blind reliance on historical results is not a sound practice.
Sometimes the past performance of a company is reflective of the expectations of the future with the exception of some identifiable nonrecurring past events. One way to account for this is for the valuation expert to adjust the historical financial results of the company so as to present them on a normalized basis. When appropriate, the adjusted, normalized historical results can then be used to form the basis for future projections.
Often a valuation expert will rely on a set of projections that bear no resemblance to the company’s actual historical performance. This, in and of itself, is not necessarily a problem, assuming that the valuation analyst conducts appropriate due diligence and bridges the past to the future (i.e., what is expected to be different about the future). However, a valuation expert will often rely on a forecast by management that is either: a) overly aggressive (i.e., it represents management’s hopes and goals as opposed to what would be relevant to an actual market participant buyer), or b) overly conservative (i.e., it represents management’s worst-case scenario and is not truly reflective of what opportunities the seller believes he or she will be giving up in the future by selling the company).
In general, the value of a business is equal to the present value of all future cash flows expected to be generated by the company in the future. Too often, a valuation expert will consider accounting-based earnings (or net income) in the valuation of a company and ignore the real value driver – cash flow. Net income on a company’s income statement prepared in accordance in GAAP is generally based on accrual accounting. Under this method, certain revenue and expense transactions are recognized in the income statement before the actual cash transaction occurs. For example, when Company A sells a product to Company B, but will not collect the cash until some future date, Company A immediately recognizes revenue on its income statement (despite not yet receiving the cash) and accounts receivable on its balance sheet related to the sale.
Common adjustments to convert net income to cash flow include: a) adding back depreciation expense (an expense that lowers net income but that is not a cash outflow); b) subtracting required capital expenditures on property, plant, and equipment line items; and c) subtracting the required investment in working capital (i.e., accounts receivable, inventory, and other current assets net of accounts payable and other current liabilities).
To calculate the present value of future cash flows when applying forms of the Income Approach, the valuation expert needs to calculate a required rate of return that accounts for the time value of money and the business risk (i.e., the risk of not achieving the projected cash flows). While certain elements of the calculation of the rate of return require some level of qualitative judgment by the valuation expert based on the facts and circumstances associated with the subject company, there are common models (e.g., the Capital Asset Pricing Model) and sources of empirical market data (e.g., Duff & Phelps SBBI Yearbook) that should typically be considered. Too often, valuation experts will use a rate of return, citing only their professional experience as a source, without considering the significant empirical market data and accepted common financial models that can serve to narrow the range of reasonable potential rate of return conclusions.
Another common mistake with respect to the rate of return used in forms of the Income Approach, even when derived more quantitatively, is to mismatch the rate of return with the cash flow. There are several ways in which this mismatch can occur. For example, if cash flow available to equity holders is being estimated in the analysis, then an equity rate of return needs to be used to calculate the present value of these cash flows. If after-tax cash flows are estimated in the analysis, then an after-tax rate of return needs to be used to calculate the present value of these cash flows.
Relying solely on a rule of thumb is one of the most common shortcuts used by untrained valuation practitioners. In these cases, the valuation expert simply multiplies a rule of thumb multiple (e.g., 10x earnings) by the financial result (e.g., earnings of $1 million) to derive a valuation conclusion (e.g., $10 million in this example). In these situations, there is typically no substantive market support for the multiple applied. Even in those situations where the multiple applied is disclosed in some sort of broker’s handbook, using a rule of thumb method is still problematic, for reasons illustrated below.
An earnings-based multiple reflects two general factors: risk and growth. The higher the risk associated with the subject company, the lower the applicable multiple. The higher the growth prospects associated with the subject company, the higher the applicable multiple. By using a rule of thumb multiple, the valuation analyst is essentially assuming that the risk and the growth prospects of the subject company are similar to the risk and growth prospects of the companies included in the rule of thumb formula. When viewed this way, it should be obvious that rules of thumb can create misleading results because the relative risk and growth prospects between companies can differ quite substantially.
Forms of the Income Approach and the Market Approach only capture the value of the core operations of the subject company. Assets that are not related to the company’s core operations need to be considered separately. For example, if a company owns excess vacant land that does not produce income and that is not needed by the business’ core operations, the value of this land should typically be added in separately in the valuation of the company. Another common example of a nonoperating asset is marketable securities.
Another common mistake by valuation analysts is to forget that a floor value (or liquidation value) needs to be considered. For companies that are not performing well, the present value of the cash flows expected to be generated in the future may result in a very low value. In valuing the subject company, the valuation analyst needs to consider whether this resulting value is so low that the company may be worth more dead than alive (i.e., through a liquidation of its underlying assets). The expertise of valuation professionals who specialize in real and personal property appraisal may be required in these situations.
Once indications of value are calculated through various valuation methods, the valuation analyst needs to reconcile the results to derive a final opinion of value. The shortcut taken by some is to simply take an average of the indications of value. It is more appropriate to consider the quantity and quality of data available that support each of the methodologies applied in order to evaluate the merits of each. For example, if three valuation methods produce diverse valuation conclusions of $50, $150, and $250, simply basing a valuation opinion on the average, $150, without any analysis as to the strengths and weaknesses of each method, can open the valuation expert up to serious criticism, especially in a cross-examination. In addition, if there is other strong evidence of market value with respect to the subject company related to market participants operating at arm’s length outside of the context of litigation contemporaneous with the valuation date, the valuation expert should be prepared to reconcile his or her conclusion of value with this indication.
What are the signs attorneys should look for to determine whether unsupported, mechanical approaches are being used? The biggest red flag is when it becomes obvious to the attorney that the valuation expert utilized some canned valuation software to perform the analysis. In these circumstances, the valuation model essentially amounts to a black box for the untrained valuation expert. Errors often occur because the valuation expert misunderstands how to enter meaningful valuation inputs into the model, thus causing a misleading conclusion. Another red flag is when the valuation analysis of the expert incorporates results indicated by a significant number of different methods (e.g., more than a dozen), each producing a very different result, and then simply takes an average of these results. When this occurs, it is often a sign that the analyst is using some canned software without completing any substantive analysis.
The above examples are by no means an exhaustive list of the errors produced by valuation experts that rely on shortcut approaches to valuation. Whether counsel is preparing his or her expert for upcoming testimony or whether an attorney is preparing questions for cross-examination for an opposing expert, the above topic areas are a good place to start to understand the thoroughness of the underlying valuation analysis.