A good time for business exit or succesion - high company multiples and before any scary tax changes?!
Valuation and pricing lessons from the battle for Sky

Beware cheap valuations (or how to intentionally overvalue a company in three steps)

You get what you pay for, and cheap ill thought through business valuations could lead to costly strategic mistakes.

499-price-tag-shadow1Last year a London based business I was working with shared with me a formal valuation they’d had done for them by a UK national business which specialises in company comparison and (ostensibly) valuation.   It had cost them less than £500.   To be precise £499 + VAT which is a not-at-all cheesy way to price it!

Of course price doesn’t necessarily give any indication of quality, or value.    Usually such cheap valuations are machine driven, very mechanistic and only as good as the assumptions fed in.  Garbage in garbage out etc. 

But what really shocked me about this report was that the basis of calculation was just plain wrong.  It looked as if it was wilfully designed to generate as high a number as possible however meaningless. 

So what was wrong with it?  Here’s my 3 biggest objections to it, which could also be read as a three step method to produce a meaningless and overstated valuation:

STEP 1: Take profit and add back ALL directors’ costs.

Valuations need to be based on a considered view of the businesses sustainable underlying level of profitability.   It’s usual to make an adjustment to private company profit figures before using them for valuation to allow for one off costs or profits.   Most commonly one needs to adjust to make sure the profit is arrived at after deducting a fair cost for the directors actual economic input to the business.   Put simply you’d add back their actual emoluments and deduct the “going rate” for the actual role they were going.  

The offending valuation just adds back ALL directors’ costs and makes no deduction, on the spurious logic that the new owners will do things differently.   But surely the business still needs managed?

STEP 2: Apply after tax multiples to before tax profits

This is mixing apples and pears and is guaranteed to give the wrong answer.   The business being valued was successful and profitable and making a good return on its assets.  So taking an earnings multiple approach was fine.  

The valuation firm used PE (price Earnings) multiples, and cited its use as a metric in the stock market.  That’s fine but it needs to be applied to after tax, after interest profit as that’s how it’s derived and used in the quoted market.  To apply it to pre-tax, pre-interest, pre-directors profit is meaningless and overstates the valuation. 

The valuer also stated that “most valuations are done this way” – actually no.   Most unquoted businesses are valued on an Enterprise Value to EBITDA basis.  And a compelling reason for that is that otherwise you need to make complicated adjustments to reflect the funding structure and taxation regime differences between benchmark companies and those being valued.

STEP 3: Add total assets to your valuation

It’s correct to add surplus assets to an Enterprise Value but not any other assets.  The logic is that the assets are involved in generating the profit stream that you’ve valued so to add them to the valuation would be to double count.  If it’s a poorly performing business you might just use the true value of the net assets as a measure of valuation but that’s a different story.

To compound it all this valuation then took the result of step 2 above and added total net assets – which in this instance added a totally spurious 50% uplift to the valuation.

At the end of the day the business owners who purchased this valuation report hadn’t wasted much money on it – but the true cost of it could easily have been poor or downright wrong decision making based on its conclusions.    After all it probably overstated valuation by nearly 60% taking all three mistakes together!  As it happens we had a discussion with them about a realistic valuation range which they used as input to their strategic discussions on exit and succession planning.  

If you're interested in the topic there's more on valuations at PEM Business Valuations


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