In Validating Business Valuations Step 1, you’ll learn to spot an improperly-prepared business valuation by:
- Listening for common deceptions and distractions used by unprofessional appraisers
- Identifying false assumptions used in improperly-prepared business valuations
Why this is important to you:
Not all business appraisers are required to follow professional valuation standards or ethics. So, Step 1: Dispel the Magic can help you to verify whether your business valuation was professionally prepared. If it wasn’t, then validating Professional Judgment and Science in Steps 2 and 3 of this section will likely be impossible.
Unlike a doctor, lawyer, or an accountant, there is no legal standard or state licensing board for business valuation practitioners. Anyone can prepare a business valuation; and with a little magic here and there, their value conclusions might seem reasonable to the untrained eye.
So how do you detect when magic was used in a business valuation? Well, it’s difficult. Just as magic results from the illusion of cause and effect, improperly prepared valuations often distort cause and effect too. You’ll look through many pages of seemingly complicated calculations; then, like magic, a value appears. You might know that something isn’t right; but just like a magic trick, disproving it will only lead to speculation and frustration. The key is to simply reject the value conclusion when you suspect that magic is present.
But, you’re not a business valuation expert. How can you be sure that what you perceive as magic isn’t actually a valid business valuation? What follows are two smell tests that can help you identify if magic is a part of your business valuation: 1) Listen for overuse of the term ‘Professional Opinion,’ and 2) Look for false assumptions.
Overuse of the term “Professional Opinion”
Imagine that you’re at the auto mechanic shop to pick up your car. As the mechanic drives your car to the front office, you notice that both front wheels wobble a bit. You ask the mechanic, “Hey, do you know that my wheels are wobbling?” He says, “Yes, that’s ok.” You respond, “Just ok?” The mechanic then replies, “Well that’s my opinion.” Without missing a beat, you volley back, “Do any other mechanics share your opinion??”
This scenario is familiar with some business appraisers as well. Non-professional appraisers, when asked to defend their value conclusions, will usually respond with one, two, or all three of these common phrases: a) “This is my professional opinion,” b) “I’ve been doing appraisals for XX years,” and c) “I’ve been in the X industry for XX years.” Let’s take a look at these comments one at a time:
“This is my professional opinion”
A ‘professional opinion’ does not mean that anyone deemed to be a professional can simply give their personal opinion. Stated another way, a ‘professional opinion’ is not defined as ‘the personal opinion of a professional.’ In fact, the more an opinion is deemed to be personal, the more it deviates from the body of knowledge that defines the profession itself. Just like the auto mechanic, you’re not really interested in his opinion. You want to know that engineering standards show that a certain amount of wheel wobble is acceptable - or more likely that wheel wobble is not acceptable at all!
The term ‘professional valuation opinion’ can be defined as “a value conclusion that is based on the professional judgment and scientific methods recognized by the valuation profession.” The key is that the value conclusion should be recognized as generally correct by any member of the valuation profession. Or, conversely, any member of the valuation profession would conclude a generally similar value.
So, if an appraiser struggles to explain the scientific methods used, or worse, if an appraiser omits certain facts or valuation methods, there’s probably a bit of magic involved. “This is my professional opinion” is simply not acceptable support for a value conclusion.
“I’ve been doing appraisals for XX years.”
An appraiser should never refer to his years of experience as the only support for his value conclusion. Yes, years of experience are important when assessing the appraiser’s qualifications (which is discussed further in the 'Appraiser Standards' section of this website); but you should demand that the value conclusion is supported by facts and logic.
Any qualified appraiser should be able to articulate the professional judgment and science used in a valuation. So, be leery of appraisers that suggest that you should accept their value conclusion simply because of their experience.
“I’ve been in the X industry for XX years.”
Having expertise in the industry of the company being appraised can be helpful in performing a business valuation. But industry expertise is not valuation expertise. An appraiser that repeatedly refers to his industry tenure as support for his value conclusion is likely claiming that he has a sixth sense regarding what businesses are worth. Unfortunately for him, there is no such thing as a sixth sense in professional business valuation.
Look for False Assumptions
All false assumptions, whether from deliberate actions or inadvertent omissions of an appraiser, still lead to magical conclusions that lack credibility. Obviously, the omissions will be harder to detect unless the appraiser reveals them or you uncover them by asking the right questions. So always ask a lot of questions!
Other false assumptions, which are more easily spotted, are described below: 1) confusing cause and effect, 2) using proprietary methods, 3) relying on rules of thumb, and a 3) broker’s opinion of value.
1. Confusing Cause and Effect
Most, if not all, business valuations are comprised of multiple different valuation methods. Keep in mind, however, that each valuation method must stand on its own merits. The validity of a particular method is based on circumstances and characteristics of the business or industry, not whether its value conclusion coalesces around the values produced by other methods.
Each valuation method can yield disparate value conclusions relative to other methods. This is normal; but the key to remember is that the appraiser must understand the valuation methods and the business thoroughly enough to understand why variances might occur. But, in no way does the convergence of values among the different methods mean that the valuation conclusion is more or less valid.
Some non-professional business appraisers even try to tweak each valuation method to force all methods to converge on a particular value, thus creating the illusion of accuracy. The logic is that if several different methods all result in the same value, then that value must be correct and reliable. Another popular tactic is to exclude a valuation method altogether if its value conclusion deviates too far from the other methods. Neither of these behaviors is acceptable under any circumstance! The valuation methods and professional judgment needed to assess the valuation methods will be discussed further in the next section of this book: Step 2: Distinguishing Art from Science.
2. The Myth of Proprietary Methods
Be leery of appraisers who claim to have proprietary methods for certain business valuations. This issue is closely tied to the appraiser described above that refers to “my opinion” or “my experience” as the support for a value conclusion. Once again, the more proprietary an opinion or a method, the more it deviates from the body of knowledge that defines the appraisal profession.
But many unprofessional appraisers use the myth of having proprietary methods as a sales tool for their services. Oftentimes, the proprietary method is coupled with the appraiser’s industry expertise as a way to falsely associate years of industry experience with having such a method. Well, there’s no such thing as a proprietary method in professional appraisal practice and you certainly won’t find such methods discussed in any of the 300+ pages of the Uniform Standards of Professional Appraisal Practice.
3. Seeing Rules of Thumb for What They Are
The Merriam-Webster dictionary defines ‘rule of thumb’ as follows:
- A method of procedure based on experience and common sense.
- A general principle regarded as roughly correct but not intended to be scientifically accurate.
Rules of thumb are a headache for professional appraisers and a holy grail for appraisal magicians. Just like an ace up the sleeve of a magician, unprofessional appraisers like to pull out rules of thumb to corroborate and support their value conclusions. Of course, after the previous discussion about manipulating methods, why not tweak all the methods to conclude a value equal to the rule of thumb? Nobody could possibly argue with that!! As you might realize, this leads to significant problems if you’re interested in getting a credible and reliable value conclusion.
Rules of thumb in the appraisal world generally relate to some sort of multiple, like companies in X industry sell for 2 times revenue. So, you might hear something like this: “as a rule of thumb, the value of Company A is $2 million because it has revenue of $1 million (Multiple of 2 times $1 million = $2 million).” That’s it. There’s your value.
The reality is, though rules of thumb are widely discussed in business valuations, there are so many factors that go into a business valuation that concluding a value that’s similar to a rule of thumb is usually pure coincidence. However, from a professional appraiser’s perspective, knowing what the rule of thumb is for a particular industry is still important; but only to dispel the magic for any believers that think they should be used to DETERMINE a value.
Now, with that said, there is one caveat: if credible data on actual sales of businesses show a statistically significant correlation between actual multiples paid and the rule of thumb, then the rule of thumb can have weight in a value conclusion. This situation occurs in the restaurant industry. No matter how profitable a given restaurant, or how sound its economics, restaurants typically sell for 0.3X revenue (30% of revenue). This rule of thumb can be corroborated by a significant number of data points. The reality is, however, that it’s these data points, and not the rule of thumb, that make the multiple credible. And just because a rule of thumb in one industry can be supported by statistical analysis does not mean that they can be similarly supported in other industries.
Remember Warren Buffet’s words that “Price is what you pay and value is what you get.” The principles of business valuation are generally based on a logical buyer and a logical seller; so there’s no assumption that a buyer will act illogically and pay a price based on a rule of thumb if the underlying economics don’t support such a price.
Here’s one example. Let’s assume that you are considering the purchase of a restaurant. There are two restaurants for sale and each has $1 million in revenue. From the rule of thumb discussion above, the value of each restaurant is $300,000 because a multiple of 0.3X multiplied by revenue of $1 million equals a $300,000 value. But, if you dig a little deeper, one restaurant makes a profit of 20% while the other has a profit of 10%. So, one of the restaurants for sale brings in $200,000 in profit ($1 million in revenue * 20% profit) and the other brings in $100,000 in profit ($1 million in revenue * 10% profit). You can see very quickly from this example that rules of thumb can be dangerous if they’re inappropriately relied upon. In this case, the gap between what you’d pay and what you’d get varies widely among these two restaurants.
So, in conclusion, professional business valuations always require a deep analysis that leads to a credible value conclusion. The value conclusion can then be converted into a multiple; and, if several company sales close at a given multiple, then a new rule of thumb can emerge. But under no circumstance should an appraiser create a self-fulfilling prophecy by using a rule of thumb to DETERMINE a value.
4. Sell-side M&A Advisors and Business Brokers Don’t Do Independent and Objective Business Valuations
Business brokers, or what Wall Street firms refer to as Investment Bankers, typically represent the ‘sell-side’ of a transaction; so, they are experts at setting an ‘asking price’ for a particular business. Conversely, professional business appraisers balance buyer and seller expectations by focusing on the business’s underlying economics, its cash-generating ability, and its growth prospects. Price is generally what the seller wants or thinks he can get; value is closer to what a reasonable buyer would be willing to pay. So, relying on a sell-side M&A Advisor or a business broker to determine the value of a business typically opens the door for upper-bound sales magic.
Now, to be clear, professional appraisers can act as M&A Advisors or business brokers; but professional appraiser ethics rules state that they must clearly disclose when they are acting as an advocate (i.e., an advocate for the seller in this case) and that their price-setting exercise is not an independent or objective appraisal. But on the flip side, when business brokers perform a business valuation, the same ethics rules don’t apply. ‘Buyer Beware’ is your only recourse if you are seeking a credible and reliable value from an M&A Advisor or a business broker.
 This is a simplified definition of value intended only for this discussion. There are multiple standards of value that each have their own definition.