Beware of 3 Common Valuation Pitfalls

  • Contributors:
  • Eric Larson

The presence of an error, misstatement or erroneous deviation from customary business valuation practice in an expert’s report is a risky proposition. Here are three common pitfalls that qualified valuation pros know to avoid — and to which less-than-qualified ones often fall prey.

1. Using Outdated Data

Business appraisals capture a company’s value at a specific point in time. Therefore, they’re contingent on the subject company’s financial health, industry trends and general economic conditions on the valuation date.

To illustrate, consider the novice appraiser who values a restaurant as of June 30, 2022, using financial data and comparable transactions from before the start of the pandemic. Operating a restaurant has changed dramatically in recent years, and the sector continues to be adversely affected by market trends, such as the high cost of food and labor, along with supply chain shortages and workplace safety concerns. Historical financial performance and many older comparables may be irrelevant when valuing a restaurant today.

2. Overlooking Adjustments

Valuation pros frequently adjust the subject company’s financial statements to reflect industry norms, arm’s-length transactions and unrecorded items. Appropriate adjustments vary from one valuation to the next.

Examples include owner’s compensation and other discretionary expenses, related-party expenses, and unusual or nonrecurring expenses (such as a change in accounting method or a gain from the sale of equipment). Failure to consider these or other appropriate adjustments can leave a valuation report with critical flaws.

3. Double Dipping

Many valuation issues overlap. For example, marketability and control are interrelated and virtually impossible to separate completely.

Suppose a valuator was estimating the value of a family business engaged in many related-party transactions. When applying the income approach, she adjusted the company’s cash flow for above-market related-party expenses and excess officers’ compensation. Then, because the company treated family members favorably, the valuator increased the company’s cost of capital. Finally, she added a control premium to her preliminary value conclusion because she was valuing a large block of stock that possessed the requisite control to alter related-party expenses.

Clearly, in this hypothetical case, there’s some degree of overlap between cash flow adjustments, factors used to build up the discount rate and the control premium. To the extent that the expert “double dipped” the effect of related-party transactions on the company’s risk and return, her value estimate may be off the mark.

Get it Right

When a valuator succumbs to one of these pitfalls, it could trigger — or worsen — an Internal Revenue Service (IRS) inquiry or perhaps lead to an embarrassing courtroom mishap. That’s why it’s critical to vet business valuation candidates and their qualifications before hiring one to handle your situation. Beene Garter, A Doeren Mayhew Firm’s dedicated Litigation Support and Valuation Group brings extensive valuation expertise to the table.

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