The Most Underutilized Tool in Business Valuation
The Use of Common Sense and Experience
The acceptance of tools such as Monte Carlo simulation and Option Pricing models has changed our ability to value options, warrants, and derivative instruments. The list goes on and on. However, as many of us are fond of saying, valuation is as much an art as it is a science. Many of our tools address the science, not so many of them address the art. In my opinion, one of the most underutilized tools that addresses the art side, may in fact be our own common sense.
â€śCommon sense is not so common.â€ť-Voltaire
Over the course of my career in business valuation, I have witnessed several fantastic tools become available to appraisers that are now commonplace in our work. The introduction of software tools such as S&P CapitalIQ and Deal Stats have revolutionized comparable company analyses and company transactions analyses. These types of tools have saved appraisers countless number of hours in searching for and analyzing data from public companies and transactions. Additionally, they help reduce human input errors as we no longer need to copy data from financial statements into Excel for our own models. The acceptance of tools such as Monte Carlo simulation and Option Pricing models has changed our ability to value options, warrants, and derivative instruments. The list goes on and on. However, as many of us are fond of saying, valuation is as much an art as it is a science. Many of our tools address the science, not so many of them address the art. In my opinion, one of the most underutilized tools that addresses the art side, may in fact be our own common sense.
There are many areas in business valuation where the application of common sense is important, such as the reasonableness of projections, the appraiserâ€™s selected discount rate, and normalization adjustments. In this article, we will focus on two areas: our choice of comparable companies and value reconciliation. First, letâ€™s examine the topic of comparable companies.
How many times have we asked our clients during the management interview what companies they consider comparable or competitors? How many times have we heard that our client, letâ€™s say a new stent company with limited sales, is comparable to Boston Scientific ($9.8 billion in sales)? This is where our common sense should tell us to dig deeper. Years ago, my associate and I were interviewing management of a metal boiler tank manufacturer. Management told us about several or all publicly traded competitors and like good appraisers, we copied down the list, excited that management already knew who their competitors were.
Back in the office and knee-deep in our analysis (and not having pulled ourselves up from the weeds yet), we noticed a large discrepancy between our Income Approach and our Market Approach. Our Market Approach was twice the Income Approach. When we examined managementâ€™s list of competitors, we noticed two things. One, they all said that they were boiler tank manufacturers. Two, not one of them actually made the metal tanks themselves. These â€ścompetitorsâ€ť outsourced the lower margin tank manufacturing business and instead focused on the higher margined control systems, electronics, etc. While these companies were much more of a value-added reseller, we were more like a contract manufacturer. Updating our Market Approach with better comparable companies resulted in a difference of less than 10%. Our common sense told us that there was an issue with one of the approaches, so we dug deeper and fixed the issue. When presenting our analysis to the client, they were surprised by our findings, yet after discussing the issue with them, they came to understand their business to a much greater degree. As a result of using our common sense, our client felt that we performed not only what they hired us for, but also became much more of a valued advisor.
A second area where common sense is needed by an appraiser is during the reconciliation of the values determined by multiple approaches. While my example above could have qualified for consideration in this category, I chose to examine the choice of the comparable companies instead. However, while that one naturally lends itself to value reconciliation, I have a better example for this category.
As a large accounting firm, our assurance clients often have valuation issues arise within their audits. Part of our policy here at Marcum is that these valuation issues should be funneled through our valuation department for a proper review of theory and methodologies (amongst other things).
A few years ago, I was reviewing a private companyâ€™s Section 409a valuation. Section 409A applies to all companies offering nonqualified deferred compensation plans to employees. The approaches utilized seemed reasonable in a vacuum, but when I reviewed the valuation reconciliation page, I noticed a large discrepancy. One approach resulted in a value of approximately $500,000 for the total equity. The second was approximately $18 million and the final approach was $21 million. Instead of reviewing assumptions and inputs like we did in the prior example, the appraiser equally weighted all three methods and determined a value of approximately $13,166,167 for the total equity. This resulted in a value of $0.35 per common share. Simply averaging three results does not necessarily make the results correct and no reason as to why such a weighting was reasonable was given in the report. Common sense would tell you that this weighting does not appear reasonable. Whether there were issues in one approach, or all three approaches, should have been addressed and the assumptions underlying those approaches should have been checked. To make the issue even worse, the company had recently closed on an armâ€™s length capital raising that was not even considered in the appraiserâ€™s analysis! In our testing of the valuation, we examined the recent capital raise and determined a value per common share of $0.36. The client and I asked the appraiser if they considered the capital raise and was told â€śnoâ€ť they had not. I asked them how they determined the weightings and we were met with silence. Finally, I asked them if they just got lucky and was told â€śyesâ€ť. Unlike our first example where we became a valued advisor, the client was not happy with his appraiser and felt like they had wasted thousands of dollars. That is not how appraisers want to be thought of by their clients and for the 409a valuation the following year, that appraiser had been replaced.
Dictionary.com defines the term â€ścommon senseâ€ť as â€śsound practical judgment that is independent of specialized knowledge, training, or the likeâ€ť. We spend thousands of hours writing articles and attending lectures on new analytical tools, resources, and theories for performing business valuations. This time and effort is focused on sharpening our specialized knowledge and training. Yet, we often underutilize our own common sense, which when combined with relevant experience, can be an equally important part of the valuation.
Bradford Taylor, ASA, CVA, is a principal in the Advisory Services Division of the Firm’s New England region. He has more than 15 yearsâ€™ experience providing business valuation, litigation support, and financial analysis services. He has worked for private and public clients across a variety of industries.
Mr. Taylor’s experience includes the valuation of business enterprises, intangible assets, and common and preferred equity for a variety of purposes, including: gift and estate tax matters, purchase price allocations, goodwill and long-lived asset impairment, stock options, intellectual property mergers and acquisitions, and other financial and tax reporting purposes.
Mr. Taylor joined Marcum in 2013 and was with a predecessor firm from 2004 to 2008. Previously, he managed the business valuation and litigation support practice at a large regional accounting firm in New England.
Mr. Taylor can be contacted at (617) 807-5215 or by e-mail to Brad.Taylor@marcumllp.com.