In October of 2003, I co-chaired a valuation roundtable session with Dr. Shannon Pratt, a highly regarded individual within the business appraisal profession. A question was asked regarding the use of market data in the market approach as it applies to the valuation of closely held companies. I thought it would be helpful to revisit this topic in this month’s newsletter.
There are three primary database sources for transactional data available to business appraisers when choosing to use the market approach. Each database collects and calculates their valuation multiples differently, but on a whole, these sources are very useful to business appraisers. Over the years, the databases have increased the amount of useful transactional information, which is then incorporated into the development of an opinion of value for a business or business interest.
Many novice business appraisers make the mistake of averaging the data from past sales transactions and applying it to a business. Over the years, I have not found too many businesses that were average in comparative operational performance to their industry peer group. Instead, most closely held businesses are more or less profitable than the industry average.
The ease of calculating an average appears to be why so many use the average valuation multiple. Non-appraisal experts, often quote the industry so called “rules of thumb” averages to use in determining the value of a business, without performing any statistical analysis as to whether or not that assumption is creditable.
Selecting the Valuation Multiple
Typically, the selection of a Price-to-Sales (P/S) and or Price-to-Sellers Discretionary Earnings (P/SDE) valuation multiple(s) can be used in developing an indication of value for very small businesses. As the size of the business increase in terms of sales and profitability measurements more complex valuation models can be employed in developing indications of value.
A qualified and accredited business appraiser will analyze the business against its industry peer group to determine if the selected multiple should be adjusted upward or downward. The business appraiser will ask certain questions and obtain privileged financial information about the operations of the business. That information is then used to analyze the business against its peer industry group.
Adjusting the Financial Information
The process of gathering and analyzing the data on a business should guide the business appraiser in qualifying the correct valuation multiple to use. I have found that further analysis of the historical financial figures is just as important.
Typically, the use of transactional market data is entrenched in the economic principle of substitution that states; “one will not pay more for an item than the amount at which they can obtain an equally desirable substitute”. Many times, we find businesses have exceptional years due to one-time events or extraordinary circumstances, (i.e. extremely high or low sales and earnings years).
For illustration purposes, let’s say a business receives a very large order in the year prior to the valuation date. Upon further analysis, it was determined this large order was a one-time event. If the appraiser applies the selected P/S valuation multiple to that year’s sales, without considering an adjustment for the one-time event, the result would be an over-valuation of the business. The opposite is true, if the business had a down turn in sales due to a one-time or extraordinary circumstance in the previous accounting period, the business would be under-valued.
As a general rule, we analyze the prior five-year gross sales periods to determine a trend line. If adjustments are warranted to the historical financial information, we document this in the valuation report. This removes a potential error for over or under valuation of the business.
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