Setting the record straight
5 common valuation myths

Business valuation is a complex financial discipline. Much of its lingo, logic and underlying mathematics can be incomprehensible to those outside the profession, giving rise to confusion and misconceptions. So let’s set the record straight concerning five common valuation myths.

1. The net misnomer

Myth: Net income and net free cash flow are synonymous - Net income is an artificial accounting concept that is quite separate from cash flow. Net income includes a deduction for depreciation expense, which many small businesses base on accelerated tax schedules rather than assets’ useful lives. And net income excludes debt service, financing proceeds, owner distributions, capital expenditures and changes in working capital. Accordingly, net income is a poor substitute for net free cash flow.

For example, consider a fictitious business with obsolete fixed assets. Its equipment is in dire need of repair and replacement, because the owner pays himself excessive distributions in lieu of making regular capital improvements. On the surface, the company may appear more profitable than its competitors because its assets have been fully depreciated and current net income includes no depreciation expense.

A novice who substitutes net income for net free cash flow risks overvaluing this hypothetical business. Net income disregards the company’s imminent need to update equipment and the shareholder’s reluctance to reinvest in future operations, whereas net free cash flow takes into account capital expenditures and working capital requirements.

In sum, free cash flow is more inclusive and more relevant to value because it represents the amount of cash available to investors (equity holders and debt holders) in excess of the current operating needs of a business — the essence of value.

2. The bottom-line blunder

Myth: Unprofitable companies aren’t worth much - Historic profits are relevant in business valuation only to the extent that they may help predict future cash flow. For example, startups and high-tech ventures may incur losses until they are up and running. Despite being unprofitable, these fledgling businesses often possess value because of their potential to generate future cash flow. Hard assets and internally generated intangibles (such as patents, customer lists and proprietary software) are also salable to a third party and, therefore, contribute value.

Profit also may be artificially suppressed for tax reasons. For example, some professional service firms intentionally minimize net income for tax purposes through partner bonuses. Cash businesses, such as car washes or restaurants, may underreport cash receipts to evade taxes. Values for these companies are often higher than their reported income would otherwise indicate.

3. The sales-price slip-up

Myth: If a competitor sold for 1.5 times revenues two years ago, a comparable business could be sold for a similar price-to-revenues multiple today - Although comparable transactions may seem to provide objective, convenient valuation evidence, a lone transaction doesn’t provide a representative sample.

Each transaction is unique. For example, a competitor’s sale might include buyer-specific synergies or unique terms, such as an earn out or employment contract for the seller. Consider, too, the reliability of the informant. Like fish stories, transaction details often become exaggerated over time or metamorphose as the story passes from one individual to the next.

The funeral industry illustrates how anecdotal valuation evidence might mislead. In the late 1990s, public companies in the funeral industry aggressively acquired small local funeral homes. Acquisition mania drove industry pricing multiples to record highs.

These roll-ups intended to introduce economies of scale and professional management. But the strategy failed and forced many acquirers into bankruptcy or reorganization. Today the industry has largely recovered, and pricing multiples have returned to more realistic levels.

4. The taxing trip

Myth: Tax status has no impact on value - In several landmark cases — including Gross v. Commissioner, Wall v. Commissioner, Heck v. Commissioner and Adams v. Commissioner — the Tax Court accepted IRS arguments that S corporations (and other pass-through entities) are worth more than otherwise identical C corporations because of their numerous tax benefits.

The most notable advantage to electing Subchapter S status is exclusion from corporate-level income taxes, including corporate-level capital gains tax after a statutory holding period. And S corporation shareholders may receive tax-free distributions as long as their equity basis in the company remains positive.

Tax-affecting S corporations remains a controversial topic in business valuation. When valuing S corporations, valuators must decide on a case-by-case basis whether to apply after-tax discount rates and pricing multiples to either tax-affected or pretax earnings. Factors to consider when making this complicated decision include the valuation’s purpose, relevant case law, the company’s distribution history and whether the business interest possesses elements of control.

5. The big one

Myth: Business value matters only when it’s time to buy or sell - This is perhaps the biggest valuation myth of all. In truth, virtually every business could benefit from a regular valuation study. From an operational perspective, many business owners have no idea what their asset is worth. An informal valuation can teach management what drives value and ways to increase short- and long-term cash flow.

Furthermore, a valuator can shed light on economic conditions and industry trends. This knowledge can improve operating efficiency and, ultimately, increase sales proceeds when the time comes.

Understanding business value is also an important part of contingency planning. For instance, it can help management assess the adequacy of commercial and key person life insurance coverage. Valuation is also an underpinning of effective buy-sell agreements, succession plans and individual wealth management planning.

One universal truth - If you are confused about business valuation, you’re not alone — its ins and outs are frequently misunderstood. An experienced valuation professional can become one of your most trusted advisors.