By Terry Silver
Special to the Legal
In the past, I have written about business valuation matters such as types of engagements and reports, assessment of risk, the management interview and where business valuation meets forensic accounting. However, when discussing this topic, I would be remiss not to share the common mistakes that are often made during this process.
Expert Selection: Once there is a decision to value a business, the valuation analyst selection process begins. How do you know if your expert is in fact an expert? The first mistake is the selection of an unqualified valuation analyst. The first acid test is credentials, including:
- Accredited in Business Valuation, ABV, issued by the AICPA
- Certified Valuation Analyst, CVA, issued by the NACVA
- Accredited Senior Appraiser, ASA, issued by the ASA
- Chartered Financial Analyst, CFA, issued by the CFA Institute
Once a properly credentialed valuation analyst is identified, the analysis of his or her judgment, which comes from experience and prior involvement in the litigation process, will narrow the field of selection.
Standard of Value: Every valuation must represent the standard of value utilized. Typically, the standard of value is either fair-market value, fair value or investment value. A common valuation mistake is mismatching the purpose of the valuation to the standard of value used. Various reasons to value a company include mergers and acquisitions, family gifting, divorce, shareholder oppression, shareholder dissent, damages, bankruptcy, shareholder agreements and financial statement purposes. Having the knowledge to properly match the reason for the valuation to the appropriate standard of value is key to establishing a credible conclusion of value.
Risk: Generally, the valuation discount rate is equivalent to risk. We comprehend risk more easily in public markets. For example, in municipal markets, would we consider a bond issued by Harrisburg, Pa., equal to the risk of a New York City bond? The valuation analyst is truly an assessor of risk. The level of risk dictates the rate of return. Mistakes in the calculation of the discount rate are common, but admittedly, sometimes subjective. Misstating the discount rate can make a significant change in the value conclusion.
Discount Rate vs. Capitalization Rate: Confusing the discount rate with the capitalization rate is a common error. While the discount rate is developed via the identification and quantification of various risk components, the capitalization rate adjusts the discount rate for a growth factor. In order to convert a discount rate into a capitalization rate, we must subtract growth because the discount rate is designed to be applied to future income streams. The discount rate is used in the discounted cash flow method, which assumes growth, while the capitalization rate is used in the single-period capitalization of income method, since no growth is assumed.
Normalization Adjustments: Another valuation error is accepting financial statements/tax returns without questioning the need for normalization adjustments. For example, in privately owned companies, certain expenses may not be representative of market value, including owner compensation, owner perquisites, rents paid to related parties, etc. Normalization adjustments may also be necessary to adjust tax-motivated accounting methods, non-recurring income or expenses, unusual litigation costs or settlements.
These five common valuation mistakes are by no means all-inclusive. In my future blog posting, I will elaborate on other commn valuation mistakes.
Terry Silver is a certified public accountant, certified valuation analyst and certified in financial forensics for Citrin Cooperman, an accounting, tax and business consulting firm in Philadelphia, where he is a partner with more than 33 years of experience as an accountant and auditor. He focuses his practice on business valuation and financial forensic services, expert testimony and matrimonial actions. He can be reached at firstname.lastname@example.org or 215-545-4800.